bkperspective real estate usa 2012

7/31/2019 BKPerspective Real Estate USA 2012

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2012

on Real Estate | U.S.


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2 | Bentall Kennedy (U.S.) LP

ACKNOWLEDGEMENTS

We would like to acknowledge the following data sources used in completing this report:

CB Richard Ellis Econometric Advisors (CBRE-EA), Commercial Mortgage Alert,

The Conference Board, CoStar, Federal Financial Institutions Examination Council (FFIEC),

IBM Benchmark, International Monetary Fund (IMF), Jones Lang LaSalle, Moodys Analytics,

Mortgage Bankers Association, National Association of Real Estate Investment Trusts (NAREIT),

National Council of Real Estate Investment Fiduciaries (NCREIF), National Federation of

Independent Business (NFIB), Real Capital Analytics (RCA), REIS, Standard & Poors,TD Economics, U.S. Bureau of Economic Analysis (BEA), U.S. Bureau of Labor Statistics (BLS),

U.S. Census Bureau, U.S. Federal Reserve

We would also like to thank the many individuals who are employed by these parties as well as

the real estate owners and managers who helped us with insights and guidance along the way.

Copyright 2012 by Bentall Kennedy (U.S.) LP

All rights reserved

The information and statistics contained in this report were obtained from sources deemed reliable.

However, Bentall Kennedy Group does not guarantee the accuracy or completeness of the information

presented, nor does it assume any responsibility or liability for any errors or omissions. All opinions

expressed and data provided herein are subject to change without notice. This report cannot be

reproduced in part or in full in any format without the prior written consent of Bentall Kennedy Group.

Perspec t ive on Rea l Es ta te 2010


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Bentall Kennedy (U.S.) LP | 3

Chapter 1 Executive Overview 5

Chapter 2 Economic Outlook 9

Chapter 3 Capital Markets 21

Chapter 4 Property Sector Fundamentals 27Apartment 28

Office 32

Retail 34

Industrial 36

About Bentall Kennedy Group 39

Contents


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4 | Bentall Kennedy (Canada) LP

Perspec t ive on Rea l Es ta te 2012 - U .S .


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More than three years have passed since the Great Financial Crisis of2008 and yet the recessionary conditions from this event feel like theyhave not ended. Optimism ran high that 2011 would see a sustainable

upswing in global economic growth. But circumstances proved to befar more turbulent than investors expected due to the escalation of theEuropean debt crisis, political brinkmanship in the U.S., a devastatingtsunami in Japan and a slowdown of the powerhouse Chineseeconomy. Annualized U.S. GDP growth averaged less than 1.0% duringthe first two quarters of 2011 and improved to a still-uninspiring 1.8%in the third quarter of the year. Real GDP did finally return to its pre-recession peak in 3Q 2011 but the 15-quarter period needed to regainthe peak was the longest in the post-war era.

The U.S. economys performance in the final months of 2011 suggeststhat growth is accelerating and we expect this trend to continue in2012. While significant risks remain, they are much more balanced than

they were a year ago. The European debt crisis and U.S. budget deficitare the primary obstacles to stronger global and domestic economicgrowth. But U.S. business and consumer confidence are slowly improv-ing in spite of these issues and the preliminary report on December2011 employment shows the creation of 200,000 jobs, one of thestrongest gains of the recovery. Unemployment fell to 8.5% inDecember, nearly a full percentage point lower than it was a year earli-er. It is possible that healthy corporate balance sheets and animproving business climate could motivate employers to ratchet up hir-ing at a faster-than-expected rate in 2012, fueling a stronger economicrecovery. A well structured and broadly supported plan developed toresolve Europes debt issues could be the catalyst for even strongergrowth.

Demographics and technology will be influential drivers of the paceand course of the economic recovery and expansion. The large EchoBoom generation is flowing into the labor force and benefiting dispro-portionately from recent hiring. Technology is heavily integrated intothis generations lifestyle and, as they represent an increasing share ofconsumer dollars, the demand for technology products will grow. EchoBoomers will also continue to be the primary driver of apartmentdemand growth.

The strong 'valuation

effect' that drove returns

in 2011 is unlikely to berepeated in 2012 but

there is no reason to

expect that commercial

real estate is not in store

for another strong

performance.

1Executive Overview1

Economy Poised to DrivePerformance in 2012


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The Baby Boom generation has not lost its relevanceand will hold a leadership role in the work force foryears to come. This generation will also be an impor-tant business driver as firms look to capitalize on theneeds of this group as its members transition out oftheir careers and into retirement. The range of indus-tries affected will be wide, including retail, leisureand hospitality, and healthcare. Aging Baby Boomerswill also fuel growth in the technology sector both asthey adopt new technologies to enhance theirlifestyles and also as firms invest and innovate tomeet the rising need for healthcare.

Clearly technology will be a pivotal driver in the nexteconomic cycle as it influences consumer behavior,gives rise to new types of office and industrialtenants, and spurs productivity. Technology is unlikelyto be the death knell for any particular type ofcommercial real estate at least not over the nextfew years but the most successful propertyinvestors and managers will be those that proactivelymake tactical and strategic adjustments to capitalizeon the changing landscape created by technologicalinnovation. There is already clear evidence that met-ropolitan areas with higher exposure to newtechnology industries are recovering at an above-average rate.

Vacancy rates fell for most types of real estate in2011 as demand strengthened and constructionactivity remained low. Stronger economic growth in2012 should only accelerate this trend. To date,apartments have been the clear winner in therecovery as demographic trends, falling homeowner-ship, and an uncertain but growing economy

produced a steady flow of new renters. The otherproperty types do not benefit directly from all ofthese tailwinds but office and industrial propertieshave nevertheless steadily improved. Lower retailvacancy rates have been more elusive but retail prop-erties should recover in a more convincing fashion in2012. Rents are already steadily increasing for apart-ments and landlords should slowly gain pricing powerin the other property types over the coming months.

Capital markets were volatile in 2011 but this volatili-ty combined with extremely low yields offered by

most assets classes resulted in strong real estateinvestment performance. The dollar volume ofcommercial real estate sales increased by 67% in thefirst 11 months of 2011 versus the same period in2010 and cap rates compressed. The yields offeredby commercial properties remain very high incomparison to U.S. Treasuries and should continue tolure investors in 2012.

Even as the net operating income generated by mosttypes of commercial real estate languished, risinginvestor interest drove very strong investmentperformance among institutional quality property

portfolios. For the year ending in 3Q 2011 theNCREIF Property Index total return was 16.1%, upfrom less than 6.0% a year earlier. The strong valua-tion effect that drove the bulk of this increase inreturns is unlikely to be repeated in 2012 but withinterest rates remaining low for the foreseeablefuture and NOI having a more positive effect onproperty performance, there is no reason to expectthat commercial real estate is not in store for anotherstrong performance.



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Bentall Kennedy (Canada) LP | 7



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2Economic Outlook

The global economic outlook sharply deteriorated in 2011 as some of therisks that surfaced in 2010, such as the potential for sovereign debtdefaults, intensified. As the deleveraging cycle grinds on, it is important to

note that many of these risks remain extensions of the financial crisis thatbegan three years ago. They should also serve as a reminder that this wasnot an ordinary cyclical recession and that the road to a full recovery willbe bumpy and take time. In such an environment, investors should beaware that the macroeconomic tail risks will remain unusually high.

Shaky U.S. and European growth prospects continue to be the primaryissue for the global economy, not only because of the large direct impactsthese regions have on global growth, but also because of the indirect impli-cations they have for other advanced and emerging economies. In the Eurozone, economic conditions have weakened significantly as a number ofheadwinds exert increasing resistance on growth. The recent escalation ofthe European sovereign debt crisis will continue to curtail consumer and

business confidence in many European countries and it is possible that arecession may already be occurring in the region. With soft global demandfor Euro zone exports and fiscal tightening insome major markets, growth prospects inEurope are likely to remain restrained well into2013 (see Fig. 2.1).

The successful implementation of structuralreforms, completion of the deleveraging cycleand a return to corporate profitability shouldusher in stronger growth in the Euro zone inthe longer run. But in the short to mediumterm, political tension among European leadersis likely to remain high and possibly grow. Thelack of progress in bringing about structuralchanges in some European countries is leadingto increased liquidity pressures at someEuropean banks and exacerbating divisionswithin the European Central Banks governingcouncil. In this turbulent environment, aEuropean financial crisis (with contagion effectsto global capital markets), a run on the Euroand even a potential break-up of the ECB aremajor risks to the economic outlook.

Investors should be

aware that the road

back to normal will bebumpy and slow with

the macroeconomic

tail risks remaining

unusually high.

The Global EconomicRecovery Stumbles

Y/Y%Change

Emerging & Developing Economies*Advanced EconomiesEuro Area

Source: IMFForecast:TD Economics Dec 2011;*IMF Sept 2011

2000 2002 2004 2006 2008 2010 2012F

-6

-4

-2

0

2

4

6

8

10

-6

-4

-2

0

2

4

6

8

10

Fig.2.1

Real GDP Growth & Outlook


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Led by China, growth in emerging markets continuesto significantly outperform the developed world. Buta key concern is Chinas economic reaction toweakness in the U.S. and European economies.Similar to most of its advanced Western counterparts,the Chinese government has lost some maneuveringroom relative to the policy actions it implemented inthe aftermath of the 2008 financial crisis. Stubbornlyhigh inflation and the need to control ballooningcredit mean that the government will be cautious inpropping up domestic demand. Accordingly, with rel-atively softer factory output and export growth, the

pace of the Chinese economic expansion is likely tomoderate to around 8.5% in the near to mediumterm. Though still very healthy by Western standards,moderating Chinese growth is a reminder of thehighly correlated nature of todays global economy.

Slow growth across larger economies will impactother markets, not just by constraining their exportsbut also by softening the previously rapid increase incommodity prices. The latter could prove to be apositive for some developing countries. Over the firsthalf of 2011, many of these economies were trying toengineer an economic slowdown to stave-off highinflation and accelerating currencies. But while someof these emerging countries concentrated theirefforts on the monetary front, their fiscal policieswere lax as their governments reacted slower thantheir central banks. A moderate decline in commodi-ty prices (or even an easing in upward pressure)would help to cool inflationary and currencypressures in developing economies, and delay anyexcessive monetary tightening that wouldinadvertently constrain growth. On the other hand,softer commodity price pressure over the near termwould have negative ramifications on growth in major

resource-dependent economies such as Australia,Canada and Brazil.

Growth in emerging markets should improve by 2013and accelerate beyond 2014 as the recovery in devel-oped countries will likely be on firmer footing bythen. But even over the longer term, emergingmarkets are unlikely to see their exports soar again,fueled by consumer borrowing in the West as had

occurred during the last decade. Instead, growth inemerging markets will need to rely more on domesticdemand. While this is certainly a very large source ofpotential growth, it will take years, if not decades, forconsumers in emerging markets to reach the samespending power as their Western counterparts.

In addition to the elevated economic risks that arenoted above, it is important to mention thatgeopolitical tensions in the Middle East will continueto have a significant impact on the global landscape,particularly in relation to the price of oil. Given a high

level of uncertainty together with the increased inter-connectivity of global capital markets, financialvolatility will remain a major theme for investors overthe forecast horizon.

U.S. Economy Improving but Risks Remain

The U.S. economy fell short of consensus growthexpectations during 2011 but continued to makeprogress toward an eventual recovery. There wascause for optimism heading into the year as jobgrowth improved in late 2010 and that momentum

carried into 2011. More than 215,000 jobs a monthwere created during the three months ending April2011, the strongest growth rate in nearly a year.


Source: Moody's Analytics, Bentall Kennedy Research

Perce

nt(%)

Jan11

Feb11

Mar11

Apr11

May11

Jun11

Jul11

Aug11

Sep11

Oct11

Nov11

0

5

10

15

20

25

30

35

40

45

50 US credit downgradeConsumer confidence dips

Stock values fall

Earthquake

strikes Japan

Debt crisis persistsStock values fall

Greece creditdowngrade

Debt concernsspread to Italy

Fig.2.2

Probability of a U.S. Recession in the Next 6 Months


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Through the course of the year, however, a numberof significant challenges took their toll on the econo-my. The March 2011 earthquake and tsunami inJapan disrupted trade flows and auto sales. Duringthe summer, the nation was held hostage by thedebate over raising the U.S. debt ceiling, a spectaclethat culminated in the downgrade of U.S. credit byStandard & Poors. Meanwhile, the European debt crisisflared, and the probability of a sovereign debt defaultby a major European Union nation rose. Pair thesedisruptions with the still-lingering U.S. housing downturnand it is not surprising that business and consumer

confidence remain shaky and growth lackluster.

According to Moodys Analytics, the probability of adouble-dip recession surged during 3Q 2011, rising fromless than 25% early in the year to 45% in September(see Fig. 2.2). This increase was tied closely to theU.S. credit downgrade and the subsequent dip inequity values. The level of economic distress doesappear to be easing, however, and stronger financialmarkets helped lower Moodys probability of a reces-sion to 34% in November. Even with this improvement,significant economic and financial market volatility,uninspiring growth, and the failure of consumer confi-dence to rally significantly keep the risk of anotherrecession elevated as we head into 2012.

Although risks abound, major indicators continue toreflect improvement in the U.S. economy. A double-dip recession, while possible, remains less likely thana continuation of this slow recovery. Real GDP grewat a 1.8% annualized rate in 3Q 2011, an accelerationfrom the less than 1.0% annualized rate experiencedin the first half of the year. Panic during the summermonths eased to worry as sovereign debt fearsmellowed, stock values rebounded, and confidenceimproved. Importantly, the level of real GDP finallyexceeds the previous high reached in 4Q 2007 butthe 15 quarters needed to regain the real GDP peak

represents the longest period in the post-war period.

While the pace of job creation has beendisappointing and employment is still more than 6million jobs below its pre-recession peak, payrollshave increased for 15 straight months. The 200,000

job increase in December was the fourth largest gainof the year and the year-over-year growth rate of1.3% was on par with the strongest growth rate ofthe recovery. A closer look at the employment statis-tics shows that private sector job growth has beeneven stronger, at 1.8% year-over-year as of December(see Fig. 2.3). Federal, state, and local government

job cuts have been a significant drag on theeconomy, with employment in these sectors declining

2Economic Outlook

Source: Bureau of Labor Statistics

Y/Y%C

hange

inEmployment Federal Government

State & Local GovernmentPrivate Sector

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

-20

-15

-10

-5

0

5

10

15

20

Fig.2.3

Private Versus Public Sector Employment


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by 1.3% during the same period. This is a significantdeparture from the prior three U.S. economic recov-eries where government employment was a source ofstability and growth, primarily due to expansion inthe much larger state and local governmentsubsector.

Aside from government job cuts, growth has beenbroad based. Retail trade, manufacturing, and evenconstruction employment are on the rise. Office-using employment was up 1.6% during the 12months ending in December as growth of 2.7% in the

professional and business services sector more thanoffset losses in the information sector and minimalgrowth in the financial activities sector.

Paramount to the continued recovery will beimprovement in business and consumer confidence.U.S. consumers continue to face high unemployment,falling home prices, persistently high energy prices,and a virtually constant barrage of negative newsabout the U.S. and European debt crises.Geopolitical tensions in the Middle East also remain avery real concern. The loss of household wealth hasbeen monumental. According to the Federal Reserve,

household net worth declined by $2.4 trillion in 3Q2011 and it is now $9.4 trillion below its 2Q 2007

peak despite the recovery of nearly $7 trillion inwealth since 1Q 2009. This loss continues to depressconsumer confidence. The Conference BoardsConsumer Confidence Index rose to 64.5 inDecember 2011, its highest level since April 2011,and a considerable improvement from its low of 25 inFebruary 2009; however, even with recent increases,the Index continues to show consumers are far fromexuberant. The Consumer Confidence Indexaveraged about 100 during 200407 and 80 over thepast 10 years (see Fig. 2.4). Looked at another way,consumer confidence has only recovered to what was

its lowest level between 2001 and 2008.

Similarly, small businesses remain more cautiousabout the future than they were prior to therecession, although their level of pessimism, as meas-ured by the NFIB, has eased since mid-2011.Employers optimism will remain tenuous untildemand for their goods and services stabilizes andgrows and the political and regulatory environmentbecomes clearer. Until that time, these factors willconstrain the pace of hiring, perpetuating the cycleof uncertainty among consumers and businesses.

According to advance estimates from the U.S. CensusBureau, retail sales in December were up 6.5% on a


Sources: Moody's Analytics, The Conference Board, NFIB

Index20

05=100

Index20

05=100

Consumer Confidence (left)Small Business Optimism (right)

0

20

40

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120

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160

75

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Jan00

Jul00

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Jul04

Jan05

Jul05

Jan06

Jul06

Jan07

Jul07

Jan08

Jul08

Jan09

Jul09

Jan10

Jul10

Jan11

Jul11

Fig.2.4

Crisis of Confidence Persists But Recent Signs of Improvement


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nominal basis versus 2010 and are 5.9% above theirNovember 2007 peak. Real retail sales, however,remain modestly lower than they were four yearsago. Declining unemployment has and should contin-ue to boost consumer confidence and retail sales.Unemployment dropped to 8.5% in December 2011,a significant decline from the 10.0% peak reached inOctober 2009. Still, the current level ofunemployment remains indicative of a relatively weaklabor market, particularly since much of the declineover the past few months is due to contraction in thelabor force. A more convincing recovery in the job

market will be needed to boost confidence and fuelstronger growth in retail spending. For now, it seemsunlikely that the economy will get much of a boostfrom consumers in the near term, despiteencouraging holiday sales activity relative to 2010.

Bentall Kennedy agrees with the consensus view ofstronger GDP growth in 2012. U.S. businesses arewell positioned for growth with low borrowing costs,high profit levels, and sufficient excess capacity toincrease production when the economy demands it.Businesses continue to increase their investments inequipment and software at a healthy pace, a trendthat has historically corresponded with job growth.Consumers will likely take their cue from the job mar-ket and as job gains continue and the unemploymentrate eases, confidence will build and consumptionwill increase.

Risks More Balanced in 2012

Unlike last year, when we thought risks to the consen-sus were primarily to the downside, we believe risksare relatively balanced as we head into 2012.

On the downside, clearly a failure of Europe tomuddle through would significantly increase therisk of another recession in the U.S., probably accom-panied by another financial crisis. Unlike many stocktraders, we do not think you should buy the rumorand sell the news but rather in this case we think thedevil is in the details and that investors should verycarefully monitor the implementation of whateverdeal is announced.

Another significant downside risk comes from thepossibility of a dramatic near-term shift away fromthe strongly expansionary fiscal policy reflected in themassive U.S. budget deficit. This could occur eitherthrough an agreement to cut spending or throughgridlock leading the way to the expiration of all Bush-era tax cuts. We have been saying for over a yearthat the U.S. must get serious about closing itsextraordinary budget deficit, but, just as with Europe,this change should not come as a sudden shock tothe system.

On the upside, it is entirely possible that therenewed job growth of the past few months willcontinue and strengthen further in 2012. If year-over-year job growth moved above 2% (roughly 250,000

jobs per month) then real GDP growth would likelycome in above 3%, consumer confidence wouldstrengthen further, and the housing recovery wouldexceed currently bleak expectations.

Another upside comes from Europe doing betterthan muddling through. While it is hard to see ittoday, a well structured and accepted debt deal inGreece and improved confidence in the fiscal plans

of Spain and Italy could ease a major expectedconstraint on global growth, allowing the strength inthe emerging markets to push global growth wellabove expectations. Euro zone strength would alsolikely lead to recovery of the Euro versus the U.S.dollar, further supporting U.S. export growth.

Drivers of Economic Growth

Demographic trends and technological innovationswill play a significant role in the recovery and thenext economic expansion. The generations that rep-

resent the bookends of the labor force will beparticularly influential. The leading edge of the BabyBoom generation is now at retirement age while theirchildren, the Echo Boom generation, now ages 17 to30, represent an increasing share of the workforce,consumer dollars, and apartment demand. With EchoBoomers driving much of the trends in consumerbehavior, technology is likely to have an even morerapidly increasing influence on the economy. This

2Economic Outlook


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CASE STUDY: ATLANTA VERSUS THE SAN FRANCISCO BAY AREA

A comparison of economic performance during the recovery in the San Francisco Bay Area 1 and Atlanta provides

an example of the importance of technology. These two markets are roughly the same size, so a direct comparison

of changes in employment levels is reasonable. During the national downturn, both areas were hit hard.

Employment in Atlanta declined by 8.5% or 210,000 jobs, while employment in the Bay Area declined by 7.5% or

143,000 jobs (see Fig.2.5). Nearly all employment sectors experienced a decline in both metros but it was notewor-

thy that losses in the information and manufacturing sectors were less severe in the Bay Area than they were in

Atlanta. The Bay Areas higher new technology exposure in these sectors was a major reason for the difference.

The contrast in performance between Atlanta and the Bay Area has become starker since national employment

began to recover in early 2010. From February 2010 to November 2011, employment in Atlanta declined by anoth-er 3,000 jobs, while the Bay Area has created 60,000 jobs. Once again this difference can largely be explained by

the performance of technology-related sectors. Atlanta has continued to experience job losses in its information

sector, which is comprised of more traditional employers in comparison to the Bay Areas technology and social

media-heavy information sector, which has grown by more than 8.0% or 7,000 jobs. Similarly, business and profes-

sional services, which contains many technology jobs, has grown at a much faster rate in the Bay Area.

Aside from differences in sectors that are directly related to technology, construction jobs are a significant differen-

tiator in the performance of these two areas. Atlantas construction sector, which is heavily dependent onsingle-family home construction, has continued to shed jobs at a steady rate. But construction has created slight

job gains in the Bay Area due to a smaller drag from single-family construction and a growing need for commercial

and multifamily space to support resurgent technology employers and their workers. Technological innovation has

and should continue to serve as a growth driver in tech-heavy metro areas. In those metros where the latest

technology firms are less prevalent, and where population growth and housing construction have historically been

key drivers, growth will be limited in the near term, as the troubled housing market keeps construction activity low.



%o

fRetailSalesChange

Source: Bureau of Labor-225

-200

-175

-150

-125

-100

-75

-50

-25

0

25

Atlanta Bay Area

Wholesale TradeTransportation & UtilitiesRetail Trade

Professional& Bus. ServicesOther ServicesNatural Resources & ConstructionManufacturingLeisure & HospitalityInformationGovernment - State & LocalFinancial ActivitiesEducational & Health ServicesFederal Government

EmploymentChange(jobs,000s)

Atlanta Bay Area-50

-40

-30

-20

-10

0

10

20

30

40

50

60

70

Fig.2.5

Jan. 2008 to Feb. 2010 Employment Trends Feb. 2010 to Nov. 2011 Employment Trends

1 The San Francisco Bay Area is defined as the total of the San Jose Metropolitan Statistical Area and the San Francisco Metropolitan Division.


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generation has grown up with technology as an inte-gral part of how they live, from education to socialinteraction, and it is sure to remain a cornerstone ofhow they function in the business world and howthey run their households.

Technology will be an influential force in US econom-ic growth and the effects will be self-reinforcing aspeople use and demand more cutting-edge technol-ogy. All else being equal, those metros withcompetitive advantages in technological innovationwill create jobs at a faster rate than those without. In

some instances, the impact of growing technologyuse and innovation will be direct in the form ofincreased office/R&D space demand and additionalhousing demand as payrolls expand. In other cases,the impact will be more subtle as technology impactsindividual behavior in a variety of ways.

As the Echo Boom generation enters the workforce,technology use will only increase. Echo Boomershave grown up with smart phones, the internet, andonline social networking as a normal part of life. Highlevels of comfort with electronic communication andonline commerce, and the ability to quickly adapt to

new technologies are likely to be characteristics ofthese young workers, raising significant questionsabout how companies will use space in the future.Echo Boomers comfort level with technology willrevive the debate about telecommuting and itsimpact on office demand and it will continue to spawnquestions about the future of brick-and-mortar retail.

Technology's Impact on Retail

Strong growth in online shopping is one clear waytechnology is having an impact on the economy.

Internet and mail order sales are steadily capturing alarger share of total retail sales (see Fig. 2.6).Shopping online appeals to consumers because itoffers convenience and the ability to hunt rapidly forthe best prices across a broad range of retailers.Technological improvements and the rise of socialmedia are only enhancing this appeal but it may alsohave something to do with growing fatigue overcrowded roads and shopping centers. As fears about

online security have steadily eased and connectionspeeds and site designs have improved, online shop-ping has grown not just among younger, tech-savvyconsumers but also among older and/or previouslyskeptical buyers. In fact, as the Baby Boomgeneration ages and becomes less and lessenamored with the prospect of traveling to ashopping center and then walking around to findwhat they need, it is likely they will become moreactive online shoppers. Smart phones will only accel-erate growth in online shopping as consumers cancomplete transactions from the palm of their hand in

minutes. This was evident during the most recent hol-iday shopping season. According to IBM Benchmark,online sales on Cyber Monday increased by 33%from 2010 to 2011 and the share of these purchasesmade on handheld devices nearly tripled.

It remains doubtful that recent surges in online shop-ping foreshadow the slow and steady death oftraditional retail. There is still no substitute for goingto the store to make sure you buy the freshestproduce or pick the clothing item with the highestquality, best fit, or most comfortable fabric. Further,online help and message boards can be useful forconsumer research, but sometimes visiting a retailerand chatting with a live salesperson is still the best

2Economic Outlook

Percen

t(%)

Source: U.S .Census

5

6

7

8

9

10

11

12

13

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Fig.2.6

Internet & Mailorder Share of Retail Sales (excl. Autos/Gas)


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way to go, at least for those of us over the age of 30.Some retail formats have attributes that are hard toenvision the internet replacing, at least for now. Theability to pick up a gallon of milk or a loaf of bread orperhaps have a prescription filled on the way homefrom work are conveniences that are hard to replicateonline. Additionally, traditional retail often offers anin-person social experience that many consumersenjoy.

The most successful retailers are likely to be thosethat can blend a strong web-based strategy with a

chain of convenient brick-and-mortar locationsstaffed with knowledgeable employees and a broadselection of items. In many instances, stores may sim-ply become showrooms for web sales and retailerscan place more emphasis on product display giventhe reduced need to store items in-house. A numberof retailers already conspicuously provide theircustomers with in-store access to their websites tobrowse prices and models not available in the store.These strategies should be effective for retailers, butthey may be bad news for retail landlords countingon a percentage of sales as part of their revenue.Alternatively, some types of retail space couldbecome nothing more than online order fulfillmentcenters with a front counter and back-room storage.This would give consumers some of the benefits ofonline shopping paired with the instant gratificationoffered by traditional retail purchases.

Technology's Impact on Office

Similar themes resonate with technologys impact onoffice space demand. Fears about telecommutinghave been swirling for years, but thus far thereappears to be no appreciable impact on space

demand. Workers may telecommute periodically, butemployers still must maintain space for thoseemployees on the days they are in the office. It isunlikely that technology will ever replace theimportance of a face-to-face meeting or the

spontaneity of an impromptu conversation at thewater cooler or in the hallway at the office whereinvaluable brainstorming, idea sharing, andrelationship-building take place. Technology can sup-port quick spontaneous communication, but anyextensive dialogue where body language and voicetone may have some value are still ideally done inperson. Webinars and other types of video-conferencing still have to be planned at mutuallyagreed-upon times and are fraught with technicalglitches. These technologies will improve, but it ishard to envision them supporting the same quality

and level of spontaneous and open dialogue that co-workers benefit from in a shared office setting.

It is telling that in one of the nations most tech-savvylocations the Bay Area plug-and-play co-workingspaces are attracting startups looking for a more pro-fessional work environment than the living roomcouch. Further, these environments may also offer theopportunity to interact with other startups in similarindustries. It seems likely that office space will contin-ue to be in demand as the economy grows,regardless of technology. Real estate investors will,however, have to monitor the type of office spacenew firms demand. Recent trends suggest that tech-nology tenants prefer more open work spaces thatfoster a collaborative work environment.Aesthetically, there is often a preference for higherceilings and exposed brick and beams that manytechnology firms feel more appropriately matchestheir casual image.

To date, technologys impact on office space seemsto be more about employers desires to foster theright work environment and boost collaboration andefficiency rather than reducing the demand for space.

Technology is clearly bolstering productivity andallowing individuals to do more work outside of theoffice. This has cut the man-power needed tocomplete certain business functions, but it shouldalso drive a stronger rate of growth that generatesmore job opportunities for qualified individuals.



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2Economic OutlookThe Echo Boom Generation

Beyond their impact on the rapidly expanding use oftechnology, the Echo Boom generation is sure todrive changes in what types of housing people live in.Much of this will be related to age as younger work-ers show preference for renting because they do nothave the financial means to buy a home or acondominium. Also, the financial commitment ofownership may not fit their lifestyle as well as rentingan apartment in an urban environment that offersproximity to work, friends, and nightlife. Echo

Boomers experiences and observations over the pasteconomic cycle will also drive these decisions. EchoBoomers watched as their parents worked hard toadvance in their careers and provide a nice home fortheir families, only to see that investment of time andwealth rewarded by stress, job loss, and plunginghome values.

It is logical to think that Echo Boomers may questionthe wisdom of homeownership and that they mayalso seek a better work-life balance than their parentshad. We expect these motives to support a strongpool of renters in the coming years as these

experiential factors elevate the already higherpropensity to rent among younger age cohorts.Couple this with the sheer volume of people enteringinto the prime renting age cohort of 25 to 34-year-olds over the next few years, and the result is acontinuation of the very strong demand growthapartments have enjoyed during the recovery to date.

The Baby Boom Generation

Meanwhile, it is fair to say that the Baby Boomgeneration may also seek a better work-life balance

than they had during the middle of their careers.They will probably look to leverage technology tospend fewer hours in the office, while continuing tomake strong and positive contributions by leveraging

their career experiences. Some members of this gen-eration may show an interest in downsizing theirhomes or moving to apartments. Others may findthemselves saddled with a home that is worth lessthan the debt they owe on it after years of borrowingfor home improvements, their childrens college edu-cation, or other expenses. Many not faced with thatfinancial constraint may simply be very happy to stayin the home they raised their family in.

What is clear is that the Baby Boom generation islarge and they will live longer than the generations

that preceded them. They may choose to stay in theworkforce longer or those with the disposition andfinancial means to do so may live long and veryactive retirements. This is a major demand wave thatretailers and the hospitality industry are trying tounderstand and capture. However, this generationwill also have some very obvious needs, primarilyrelated to healthcare. The demands on the healthcareindustry for long-term medical treatments,orthopedic surgeries, and a whole host of other med-ical needs will keep rising. This trend will prop updemand for new medical centers and medical officespace and also encourage continued innovation bybiotechnology and pharmaceutical firms.

Successful real estate investing in the coming yearswill depend upon a strong understanding of thesetechnological and demographic forces and how theywill drive growth. Attentive asset management andthoughtful acquisitions and dispositions will be neces-sary to ensure commercial real estate portfolios offerthe right types of environments to lure new tenants.As the varying pace of the recovery indicates to date,location selection will also remain paramount as somemetro areas and submarkets are better-positioned to

capitalize on the needs of the population and thegrowth of the technology companies looking to servethem.


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19/40




20/40




21/40


Financial markets remained volatile during 2011, with the S&P 500stock price index rising nearly 8% in the first four months of the year,only to be down 10% by the end of September. Investors poured inand out of stocks based on the headlines of the day and, with newslargely negative in recent months, stock prices suffered. This volatilitywas evident as recently as November when a late-month rally savedthe markets from what was shaping up to be a large drop in value.December was a quieter month and the S&P 500 index managed toclose the year unchanged versus the end of 2010. Conversely, Treasuryprices steadily rallied as investors sought safer investments and theFed implemented its second round of quantitative easing (see Fig. 3.1).The 10-Year yield averaged less than 2.0% in September and December.

The REIT market was not immune to volatility in the broader markets.After being up 12.6% for the year in May, the NAREIT All Equity priceindex was down 8.5%year-to-date as ofSeptember. REIT pricesrallied back in Octoberand, after a brief setbackin November, finished2011 with a 4.3% gain.Performance variedacross property typeswith residential REITsshowing the best

performance of themajor property types onthe shoulders of strongapartment propertyfundamentals. Office andindustrial REITs closedthe year with negativetotal returns.

Sources: Standard & Poor's, Federal Reserve

S&P500

IndexLevel

10-YrTreasuryRate(%)

S&P 500 Price Index10 Year Treasury Rate

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig.3.1

Capital Market Trends

The high volatilityand/or low yields offered

by other asset classes and

modest improvement in

real estate fundamentals

have clearly been a boon

to direct commercial real

estate investment.

Volatility Persists ButInvestor Interest Grows

3Capital Markets


22/40


In the context of weak retail property performance,expectations would have been for poor retail REITreturns as well, but stellar performance by the majorregional mall REITs particularly Simon Propertiesthat dominates this sector offset weakness in theshopping center and freestanding store subsectors.Strong locations, credit tenants, and a lack of newsupply are benefiting major malls. According to datafrom NCREIF, regional and super-regional mall NOIrose 3.7% during the four quarters ending 3Q 2011,while NOI for all other types of retail was flat.

The high volatility and/or low yields offered by otherasset classes and modest improvement in real estatefundamentals have clearly been a boon to directcommercial real estate investment, particularly forwell-leased assets in major markets. According todata from Real Capital Analytics, year-to-datetransaction activity through September 2011surpassed the full-year 2010 total. ThroughNovember 2011, $162.8 billion of property had trad-ed, the highest level of activity since the first 11months of 2007 and a nearly 67% increase from thesame period in 2010. Strong increases were seen

across all major property types. Retail was on pacefor more than twice the activity it experienced in2010. Activity did slow later in 2011 as investors feltthe effects of broader economic and financial marketconditions. Transaction dollar volume fell nearly 19%between 2Q and 3Q 2011. That trend continued inOctober and November, putting 4Q 2011 activity ona pace to be lower than 4Q 2010 (see Fig. 3.2).

Volume in November was down from a year ago, thefirst year-over-year decline since October 2009. Evenwith this slowdown, liquidity in the market was clearlyat a more healthy level in 2011 than it had been for

some time.

A meaningful turnaround in property values has beenless evident than the improvement in transaction vol-ume. Indices such as the Moodys/REAL CommercialProperty Price Index and the CoStar CommercialRepeat-Sale Indices have yet to show a convincingrecovery trend in property values, although recentmovements have been positive. According to theseindices, values were still 30% to 40% off their peaklevels at the end of 3Q 2011. Pricing bifurcation isclearly evident in the market. The NCREIF Property

Source: Real Capital Analytics* 2011Q4 Data Through November

Billions($)

0

20

40

60

80

100

120

140

160

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig.3.2

U.S. Transaction Volume (2001 - 2011*)Fig. 3.3

U.S. Commercial Property Values


Moody's/REAL CPPINCREIF Transaction Based IndexNCREIF Price Index

Source: Moody's/REAL* 2011Q4 Data Through November

PropertyValue

Index(2007Q3=100)

40

50

60

70

80

90

100

110

01Q2

02Q2

03Q2

04Q2

05Q2

06Q2

07Q2

08Q2

09Q2

10Q2

11Q2


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3Capital Markets

Sources: NCREIF (transaction-based cap rates), Federal Reserve, Moody's Analytics

CapRate/

TreasuryRate(%)

S

pread(bps)

-2

-1

0

1

2

3

4

5

6

7

8

9

10

-200

-100

0

100

200

300

400

500

600

700

800

900

1,000

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Cap Rate SpreadCap Rate 4 Qtr Moving Avg.

10-Year Treasury25-Yr Average Spread

Fig.3.4

U.S. Cap Rate Trends Relative To Treasuries

Index and NCREIF Transaction Based Index, whichreflect trends in institutional-quality real estate,suggest values have been recovering since early 2010(see Fig. 3.3). Meanwhile the Moodys/REAL andCoStar indices, which attempt to capture the overallmarket, have languished. Well-leased assets partic-ularly those with solvent, institutional ownership inmajor US cities are seeing stronger investor interestthan the broader market and their values have madesignificant progress towards a recovery. Conversely,where there is more distress and weaker investorinterest, values have been bouncing along the

bottom. The good news is that all of these indicesdid show varying levels of growth in 3Q 2011 andmore recent monthly data have been positive, whichis an encouraging sign as we head into 2012.

A sub-index of the Moodys/Real CommercialProperty Price Index gives us another look at pricingdifferences across markets. The groups six-cityTrophy index (which contains properties sold in New

York, D.C., Boston, Chicago, Los Angeles, and SanFrancisco valued at more than $10 million that arenot in distress) increased by 32% from December

2009 to September 2011. The overall CommercialProperty Price Index declined by 2.0% during thesame period. These trends have obviously rewardedproperty owners in the major markets and attractedadditional capital interest in the form of both acquisi-tions and development.

Cap rates tell a more favorable story about howinvestors are valuing commercial real estate. NCREIFtransaction-based cap rates spiked from 5.62% on arolling four-quarter-average basis in 1Q 2008 to8.15% in 1Q 2010 but they have steadily fallen since

that peak, reaching 6.76% in 3Q 2011 (see Fig. 3.4).Declining property NOI was the trigger for some ofthis compression, but stronger investor interest as thefinancial crisis eased and the poor performance ofinvestment alternatives were also significant drivers.

The low current yields offered by other investmentshave helped lure capital into commercial real estate.Relative to their recent history versus the 10-YearTreasury rate, cap rates are extremely attractive. The3Q 2011 spread between cap rates and the 10-Yearwas 433 basis points, nearly 200 basis points above


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its average over the past 25 years. By comparison,real estate was selling at an average premium of just164 basis points to the 10-Year from 2005 to 2007.Further, at the time of this writing, the 10-Year yieldis more than 50 basis points lower than its 3Q 2011

level. Not only does the cap rate spread suggest cur-rent real estate yields are attractive, it also suggeststhat cap rates could remain stable even in the face ofa relatively significant interest rate shock.

The debt markets give us another perspective on thecondition of real estate capital markets. According tothe Mortgage Bankers Association, commercial andmultifamily loan originations have been trendinghigher since early 2010 and activity in 3Q 2011 wasthe highest since 4Q 2007. All major types of lendingsources increased their activity between 3Q 2010 and3Q 2011, led by a 433% increase for commercial

banks. Originations are still well off the levels of200507, but appear to be returning to the levels of200304. The October 2011 Federal Reserve Senior

Loan Officer Survey showed a narrow majority ofbanks are both loosening their underwritingstandards for commercial real estate loans and seeinggrowth in demand for these types of loans (see Fig.3.5). Commercial real estate loan performance hasbeen improving, with data from the Federal FinancialInstitutions Examination Council showing decliningcharge-off and delinquency rates at US CommercialBanks. These measures are still elevated relative tohistorical levels but have come off significantly fromtheir recent highs.

Improvement in the CMBS market has been less con-vincing and CMBS delinquency rates remain veryhigh. According to the Moodys CMBS DelinquencyTracker, 9.29% of all loans were 60 days or more pastdue in October 2011, not far below the 9.36%cyclical peak reached in the prior month. The marketwas essentially frozen from the latter part of 2008through early 2010, but activity has been increasing.Originations reached $32.7 billion in the US for the12 months ending in December 2011, up from a lowof around $560 million in mid-2009, according toCommercial Mortgage Alert; however, this is still wellbelow the nearly $280 billion in issuance completedduring the 12 months ending in August 2007. It isnotable that originations in 4Q 2011 were by far thelowest of the year as economic and financial marketuncertainty crimped the pipeline of new deals. CMBSshould re-emerge as an important source of debtfunding for commercial real estate investors, butsome of the very high profile loan defaults underlyingCMBS issuances from the peak of the cycle,persistently high delinquency rates, and broaderfinancial market volatility have done little toencourage skeptical investors to return to the market.

Real estate investment returns should only encourageadditional capital to flow into the asset class.Institutional-quality real estate posted a stellar


Net % of Banks Tightening CRE Lending StandardsNet % of Banks ReportingStronger Demand for CRE Loans

Source: Federal Reserve Senior Loan Officer Survey

PropertyVa

lueIndex(2007Q3=100)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-80

-60

-40

-20

0

20

40

60

80

100

Fig.3.5

U.S. Commercial Real Estate Lending Environment


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performance during the year ending 3Q 2011, withthe total return for the NCREIF Property Index reach-ing 16.1% (see Fig. 3.6). This performance was drivenlargely by a recovery in depressed property values;however, stabilizing cash flows due to improved fun-damentals are also having a positive impact. NOIincreased during the period after declining in 2009and 2010. NOI growth was driven primarily by theapartment market, which experienced a nearly 11.0%increase in NOI.

The other property types are not as far along in their

recovery as apartments. Office and industrial NOI fellby just over 1.0% and retail NOI rose modestly.Without significant NOI growth, office, retail, andindustrial properties still managed total returns northof 15.0% largely due to the positive valuationeffect created by strengthening investor interest(see Fig. 3.7). Volatility and low yields in other assetclasses and the prospect of improving propertyperformance encouraged investors to accept increas-ingly lower yields during the year ending in 3Q 2011.

More aggressive investors pushed values oninstitutional quality office, retail, and warehouseproperties up by more than 8.0% despite the lack ofNOI growth. Apartments experienced less of a valua-tion effect over the past year due to their already lowyields and the rapid increase in prices driven by twoyears of rising NOI.

As confidence in the recovery builds, investors shouldcontinue to target commercial real estate andtransaction volume is likely to build off the growthexperienced in 2011. Investor interest in secondary

markets and properties with higher levels of vacancymay rise in 2012, but given the likelihood thatfinancial markets will remain relatively volatile, qualityproperties in primary markets should continue to gar-ner the lions share of capital. Investors shouldtemper their expectations for valuation-driven returnsin 2012 as the pace of cap rate compression slows. Ifthe economy improves as expected in 2012, however,NOI growth should be a more significant driver ofreturns.

3Capital Markets

Income ReturnNOI Growth

Valuation EffectTotal Return

Percent(%)

-30

-25

-20

-15

-10

-5

0

5

10

15

20

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

* Years ending in the third quarter

Fig.3.6Decomposition of NCREIF Returns*

Fig.3.7Decomposition of NCREIF Returns by Property Type - 2011*

Source: NCREIF, Bentall Kennedy

Percent(%)

-5

0

5

10

15

20

Apartment Industrial Office Retail


26/40




27/40


4Property Sector Fundamentals

Sources: CBRE-EA, REIS** 2011Q3 forecast* Apartments in units; all others in thousands of square feet

Property Type 2011Q3 Stock* Vacancy Annual Supply Growth Year-over-Year Rent2011Q3 Year-Ago 2011** Past 10 Yrs. Growth 2011Q3

Apartment 9,837,685 5.6% 7.1% 0.4% 0.9% 2.3%

Office 3,577,546 16.2% 16.7% 0.3% 1.8% 0.9%

Industrial 12,730,225 13.7% 14.5% 0.2% 1.4% -1.2%

Retail 2,759,474 13.2% 13.1% 0.2% 2.1% -3.7%

Fig.4.1Property Sector Summary Statistics

Recovery in FundamentalsSlowly Gaining HoldU.S. property markets tightened during 2011 assteady but unimpressive job gains drove increaseddemand for space. Apartment, office, and industrial

vacancy rates were all lower in 3Q 2011 in comparisonto 3Q 2010 (see Fig. 4.1). The retail vacancy rateinched higher during the same period, but fell slightlyduring the quarter. Preliminary data suggestsapartment, office, and industrial vacancy rates continuedto fall in 4Q 2011 and retail vacancy remained flat.The momentum of the property market recovery shouldbuild in 2012 as U.S. economic growth accelerates.

Limited new construction has been a boon to U.S.commercial real estate markets and the lack of newsupply will continue to be a positive factor over thecoming year. During 2011, the inventory of space

across the major property types grew at just afraction of its pace over the past 10 years (see Fig.4.1). Risks from new construction will remain limitedas rent levels do not support development in themajority of property types and markets. That said,construction completions are likely to steadilyincrease over the next few years as developers lookto capitalize on space shortages and aggressive pric-ing in some markets, and expanding owner/userssupport an increasing amount of activity.

With vacancy rates still well above equilibrium levelsin most major property types, rent growth will be farfrom robust in 2012. Industrial and retail rents continued

to fall nationally during 2011, and only the apartmentmarket registered meaningful growth. As commercialvacancy rates continue their slow declines, landlordsshould gain more pricing power in 2012. Apartmentsshould see strong rent growth over the coming yearwith growing demand and vacancy rates below theirpre-recession levels. In property types and marketswhere the rent recovery is still in its early stages, thereis the potential for significant rent bumps, particularly inhigher-growth technology markets.

Commercial property markets will benefit from anumber of tailwinds in 2012 and beyond. Stronger

economic growth and favorable demographic trendswill drive more substantive improvement in demandfor space while activity on the supply-side remainsrelatively tame. However, significant risks continue toloom in the background. The still-unresolved domes-tic and European debt crisis and considerablegeopolitical turmoil have the potential to sidetrackthe recovery. Additionally, a lack of clarity on thepolitical and policy environment could deter hiringuntil after the U.S. presidential election.


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Apartment


The apartment sector is experiencing the strongestrecovery of the major U.S. property types asdemographic trends, the weak for-sale housingmarket, and an uninspiring, but growing job markethave generated new demand. Vacancy rates havebeen tightening briskly (see Fig. 4.2). As of 3Q 2011,apartment vacancy was 2.4 percentage points belowits 1Q 2010 peak and preliminary data suggest thatthe vacancy rate fell below its pre-recession level inthe fourth quarter. Net absorption has been positivein the apartment market for 11 consecutive quarters.

After almost two decades of rising homeownership,renting came into increasing favor as the recession hitand home values collapsed. The homeownership ratefell to 66.3% in 3Q 2011 after peaking at 69.2% in2004. This unprecedented decline occurred asfamilies lost their homes to foreclosure and otherswere scared off by tighter lending standards andfears about the stability of home prices. According tothe S&P/Case-Shiller National Home Price Index,home prices fell by approximately one-third between1Q 2006 and 3Q 2011, including a roughly 4.0%decline over the past four quarters. With the declinein home prices ongoing, many potential buyers are

making the decision to stay on the sidelines and rent.

Undoubtedly these trends were magnified by theeconomy. High unemployment and fear of job losshave discouraged households from making the long-term commitment to a mortgage, perpetuating thedecline in home values. While economic conditionshave improved, the recovery has not been strongenough to diminish potential homebuyers fears.Instead, meager job gains have primarily drivengrowth in new renter households.

U.S. Census data also indicate a significant trendtowards the doubling-up of households during the

recession. Not only were individuals making decisionsnot to buy homes, they were also entering intomultiple roommate situations, moving in with parents,or even entering into multiple family living arrange-ments. This trend reversed itself somewhat in 2011,but the Census Bureaus data still show a 10.7%increase in doubled-up households and a 25.5%increase in 25 to 34-year-olds living with their parentsin comparison to 2007. Clearly an impactful level ofdemand will be created when more compellingeconomic news encourages these individuals to formnew households.

A deeper look at employment trends also shows thatjob creation has disproportionately benefited agegroups with a higher propensity to rent. Youngerworkers were hit hard by layoffs during the recession,but since total employment bottomed in late 2009(according to the BLS household survey),employment among 25 to 34-year-olds has increased3.0%. Employment among all other age groupsincreased just 1.6% during this same period. Part ofthis growth is attributable to shifts in the age compo-sition of the labor force, which has grown by 0.5%overall and by 1.9% for 25 to 34-year-olds during the

recovery, but it is clear that hiring is benefitingyounger workers and this has been a favorable trendfor apartment demand.

Growth in the number of potential workers ages 25to 34 is a demographic phenomenon linked to theEcho Boom generation. The size of this age cohorthad been flat to down on an annual basis since thebulk of the Baby Boom generation exited out of itSource: REIS

ChangeinSupply/

Demand(Units)

Vacancy(%)

Change in SupplyChange in Demand

Vacancy

-100,000

-50,000

0

50,000

100,000

150,000

200,000

250,000

9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9 1 0 11 12 13 14 15

0

1

2

3

4

5

6

7

8

9

Fig.4.2

Apartment Fundamentals


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Source: U.S. Census Bureau

3MonthMovingAverageof

StartsandPermits(SA,000s)

Multifamily Starts - 5+ UnitsAverage Permits 2001 to 2010Multifamily Permits - 5+ Units

0

200

400

600

800

1,000

1,200

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Fig.4.3

Multifamily Permits and StartsFig.4.4

Metro Apartment Market Performance

around two decades ago. Over the next few years,the arrival of the Echo Boom generation will lead thesize of this cohort back above its 1989 peak. If theeconomy is able to create enough jobs for this group,apartment demand will continue to increase strongly.After seeing the American Dream of home-ownership turn into a nightmare of foreclosures andfinancial destruction, Echo Boom generationmembers are sure to have a skeptical view ofhomeownership. Bentall Kennedy expects that thepropensity to rent will remain high among this groupas they show preference to the personal and financial

flexibility offered by renting.

While all of these factors have bolstered the demandside of the apartment market, new construction hasremained muted. The delivery of new apartments hassteadily fallen over the past two years and averageannual completions during 201011 were about 40%less than the average during 200709. Multifamilyconstruction activity is increasing again but the prop-erty type is a long way from being flooded with newsupply. Despite steady increases over the past twoyears, multifamily permitting activity in 2011 was 43%below the average level experienced during the

previous 10 years (see Fig. 4.3).

Apartment fundamentals and the pace of recoveryhave varied significantly across markets. Demandgrowth over the past year has been strongest in New

York, where uncertainty in the financial services sectoris discouraging would-be homebuyers. New York isthe only major market where the rate of apartmentdemand growth over the past year exceeds thecurrent level of vacancy (see Fig. 4.4). Under theseconditions the market will be incredibly tight for theforeseeable future. REIS projects that New Yorksvacancy rate will fall below 2.0% in 2013. Major Texasmarkets, which are benefiting from strong economic

growth with the help of the energy sector, are alsoperforming well. Housing bust metros such asPhoenix and Atlanta have also posted impressivedemand-side growth, driven by modest job gains anda collapse in homeownership.

The majority of markets have very low vacancy ratesdespite largely unimpressive demand growth, whichshould give even more pricing power to landlords in2012. In the tightest markets, the only obstacle torobust rent increases may be the ability and/orwillingness of renters to pay more in the face of ashaky and slow-growing economy, and increasingly

attractive home values. Despite significant demand

Source: REISNote: bubble size = inventory

DemandGrowth2010Q3to2011Q3

Vacancy 2011Q3 (%)0.0 2.0 4.0 6.0 8.0 10.0 12.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Detroit

District of Columbia

Chicago

Los Angeles

Philadelphia

NorthernNew Jersey

New York DallasHouston

Atlanta

Seattle

Phoenix

Minneapolis

Orange CountyBoston


30/40


Apartment


recoveries in some housing bust rental markets, thedeep employment losses suffered by these metrosshould temper the ability of landlords to push rents.Somewhat ironically, the failure of new homeconstruction to rebound will also be a hindrance inmarkets where housing and construction have histori-cally been crucial drivers of economic expansions.Markets with strong technology sectors shouldcontinue to perform well. Technology-focusedeconomies such as Boston and Seattle are experienc-ing relatively healthy recoveries and solid apartmentdemand.

As members of the Echo Boom generation reachapartment-renting age in increasing numbers overthe coming years, the economy continues to recover,

and households uncouple, growth in apartment-rent-ing households is inevitable. The much-improvedaffordability of homeownership will eventually drawsome renters back into the for-sale market, butBentall Kennedy does not anticipate a return of thehomeownership rate to pre-recession highs. Apartmentconstruction completions should steadily rise over thenext few years, but vacancy is at a very healthy levelin most markets and there is no sign that constructionis ramping up to levels that would prevent furtherimprovement in the market. Rent growth should con-tinue to strengthen, particularly if the economic

recovery gains steam in 2012 as expected.


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32/40


Office


Source: CBRE-EA

ChangeinSupply

/Demand(SF000s)

Vacancy(%)

Change in SupplyChange in DemandVacancy

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

-100,000

-75,000

-50,000

-25,000

0

25,000

50,000

75,000

100,000

125,000

0

2

4

6

8

10

12

14

16

18

Fig.4.5

Office FundamentalsFig.4.6

Office Using Employment vs. Other Employment Sectors

The office market clearly improved in 2011, but thepattern of the recovery was mixed. According toCBRE Econometric Advisors, the office recoverypaused in 3Q 2011, but the vacancy rate was stillabout 50 basis points lower than it was a year earlier.Weaker economic conditions during mid-2011 result-ed in lower demand growth in 3Q 2011. Preliminarydata suggest that vacancy fell again in 4Q 2011, leav-ing the rate lower for the second straight calendaryear (see Fig. 4.5).

Office-using employment is the primary indicator of

office demand and, even with the recent slowdown,the recovery in this sector has been stronger than inmost other employment sectors (see Fig. 4.6). Office-using employment has grown by 2.6% since February2010 (when total employment reached its trough),while all other sectors have grown by 1.9%. Growthin the professional and business services sector hasbeen the primary driver of office-using job creation.Growth has been particularly strong in technology-heavy subsectors such as computer systems designand management and technical consulting services.As would be expected in a recovery where manyemployers are reluctant to make long-term

investments, the temporary help services subsectorhas also grown rapidly.

The other two major office-using employment sectors financial activities and information haveperformed poorly. Financial activities employmentgrew by just 0.1% in 2011 as financial market turmoilkept employers on edge and prompted a number ofinstitutions to cut jobs. This lack of growth took amajor source of demand out of the equation formany metros. When a path out of the debt crisis isclearly defined and financial markets stabilize, this

sector could quickly become a significant source ofdemand. Information sector employment declined,with more traditional telecommunications, broadcast-ing, and publishing employers in this sectorparticularly hard hit, while internet and software com-pany employment expanded. This dichotomy hasdriven differences in metro office marketperformance based on employment concentrations,with technology-focused markets experiencingstronger growth.

Differences in the rate of job growth have beenevident in the demand growth rates of the various

Source: Bureau of Labor Statistics

Y/Y%

Growth

Office Using EmploymentAll Other Employment

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-8

-6

-4

-2

0

2

4


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5 10 15 20 25 30

Source: CBRE-EANote: bubble size = inventory

DemandGrowth2010Q3to2011Q3

Vacancy 2011Q3 (%)

Edison

Dallas

Chicago

Los Angeles

Philadelphia

WashingtonD.C.

New York

Houston

Denver

Atlanta

Seattle

Phoenix

San Francisco

Newark

Boston

-2

-1

0

1

2

3

4

Fig.4.7

Metro Office Market Performance

metro office markets. Metro areas with vibranttechnology sectors such as San Francisco and Seattleexperienced strong demand growth over the pastyear, while most metros with lower technologyconcentrations such as Newark and Atlanta struggled(see Fig. 4.7). Technology has not, however, been theonly driver. Houston posted stellar growth in officedemand over the past year and a full percentagepoint decline in its vacancy rate due primarily to theexpansion of the energy sector. Conversely,Washington, D.C. coped with weak demand due tobelt-tightening by the Federal government and its

contractors. Phoenixs sharp employment deficit rela-tive to its pre-recession peak and only modest jobcreation have crimped office demand, in starkcontrast to its apartment market, which was amongthe leaders in demand growth.

The broader observation about the office market isthat vacancy rates remain high in many metros areasand expectations for rent growth should betempered. That said, not all markets are on equalfooting and properties in tighter markets such as New

York, San Francisco, and Boston should continue their

progress towards a full recovery in rents during 2012.

The lack of a stronger economic recovery is a concernfor the office market, but healthy corporate balancesheets and growing business investment bode wellfor future growth. Real corporate profits have nearlyrebounded to their pre-recession highs and businessinvestment in equipment and software has beensteadily growing since 3Q 2009. Business investmentin equipment and software usually foreshadows hiringin office-using employment sectors.

Additionally, not unlike the apartment market, theoffice market is getting a significant boost from adearth of new supply. As measured by CBREEconometric Advisors, office space inventory grew by

just 9 million sf in 2011, the smallest increase sincethe early 1990s. High vacancy rates and significantlyreduced rents should continue to suppress newconstruction activity in the office market, allowing foradditional improvement in vacancy and rents even ina relatively benign demand-side recovery.


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Retail


Source: CBRE-EA

ChangeinSupply/Demand(

SF000s)

Vacancy(%)

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15


-100,000

-75,000

-50,000

-25,000

0

25,000

50,000

75,000

100,000

125,000

0

2

4

6

8

10

12

14

* Data includes neighborhood and community

Fig.4.8

Retail* FundamentalsFig.4.9

Retail Sales Trends

A recovery in retail property fundamentals has notbeen nearly as evident as it has been in the otherproperty types. According to CBRE EconometricAdvisors, retail property fundamentals improvedslightly in 3Q 2011, with the vacancy rate falling 0.1percentage points to 13.2%. 3Q 2011 was the firstquarter of the year to experience positive netabsorption. However, considering that the retailvacancy rate was at a record high level in 2Q 2011,this small improvement did little to brighten the out-look for retail properties. Preliminary data suggestthe retail vacancy rate was flat in 4Q 2011, despite

extremely low levels of new supply, and finished 2011slightly above its level at the end of 2010 (see Fig.4.8). Retail rents continued to fall at a fairly steadypace and were down nearly 4.0% for the year endingin 3Q 2011.

Headline retail sales figures are encouraging. Afterenduring an unprecedented decline during the down-turn, the level of spending has pushed back above itspre-recession highs on a nominal basis. Year-over-yearretail sales growth of 6.5% in December 2011 isindicative of a very healthy market (see Fig. 4.9);however, real retail sales remain below their pre-

recession highs. Additionally, much of the growth insales has been focused outside of traditional brick-and-mortar retail stores. Growth in retail salesexcluding autos and gasoline was a somewhat morepedestrian 5.5%. The growth rate drops even lower,

to 4.9%, when non-store retailers (i.e. internet andmail order) are backed out. Non-store retailersaccounted for just under 12.0% of sales excludingautos and gasoline in December 2010, but they wereresponsible for nearly 29% of growth over the follow-ing 12 months. Internet shopping is clearly becomingan increasingly important force in retail. According toIBM Benchmark, Cyber Monday sales were up 33%between 2010 and 2011. The share of these onlinesales completed on mobile devices nearly tripled dur-ing the same period.

Retail sales data also show consumers are avoidingpurchases of items that are not necessities. The datasuggest that growth in sales at furniture and homefurnishings, electronics, and sporting goods, hobby,book, and music stores has been particularly anemic.Some of this activity (particularly books and music) iscertainly being absorbed by online sales, but clearly,many traditional brick-and-mortar retail formats arestruggling.

As mentioned previously in this report, the increasinguse of technology is influencing how consumers shopand this trend will have a varying impact on the

different retail formats. The strong performance ofregional and super regional malls over the past yearis largely due to location and tenant quality, but italso seems logical that destination retail may havesome resistance to cannibalization from the internet.

Source: US Census Bureau

Billions($),SA

0

50

100

150

200

250

300

350

400

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10


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4Property Sector FundamentalsThe social experience of shopping (and perhaps din-ing and/or watching a movie) at these larger retailformats may be unique enough to fend off a dramaticloss of sales due to online shopping. On the otherend of the retail spectrum, convenience retail, such asthe neighborhood grocery store or drug store, isunlikely to be replaced by the web; however,standalone retail stores, strip centers, and power cen-ters may be particularly vulnerable to growinginternet sales. Many retailers work hard to keep traffichigh at their stores by offering productdemonstrations and free samples, but it seems

inevitable that the internet will continue to grab anincreasing amount of the retail sales pie. Thechallenge for retailers will be to successfully adaptand implement strategies that create synergiesbetween their stores and websites.

There are more immediate concerns for retaildemand as well. The encouraging holiday shoppingseason aside, eroding household wealth and highunemployment are not a recipe for stellar retail salesand rising demand for retail space. In fact, much ofthe recent growth in retail sales has come at theexpense of savings as growth in disposable personal

income has stalled in recent months. The personalsavings rate fell from about 5.5% in mid-2010 to 3.5%in November 2011. While this is still higher than thesavings rate leading up to the recession, it is lowenough to suggest that any new slowdown in

economic growth would significantly impair the abilityof households to spend. This concern is magnified bythe growth in consumer credit over the past year.

If economic growth improves as we suspect in 2012,there is a silver lining to recent data. Consumers haveclearly shown an increased willingness to spend andhouseholds are operating on a less conservative basisthan they were during the depths of the recession.Some of this may be out of necessity after a protract-ed period of limited spending, but it is also likely thatrecent improvements in consumer confidence are

having a tangible impact on spending.

Nationally, the demand for retail space grew at aslower rate than the three other major property typesand there were no real bright spots at the metro level(see Fig. 4.10). Relatively healthy economies such asBoston and New York saw limited demand growthduring the year ending 3Q 2011, but they do benefitfrom comparatively low vacancy rates. Even Seattle,where job growth was well above the national averagein 2011, had demand growth of just 1.0% and thiswas one of the strongest growth rates of the majorU.S. metros. Weak demand growth in Houston and

Dallas was perhaps even more surprising given thegrowth of those economies. Housing bust metros suchas Atlanta, Phoenix, and Riverside had declining or nearlyflat demand during the period and relatively highvacancy rates, reflecting their still-weak economic condition.

Demand will be the primary determinant of retailproperty performance in the coming year as new con-struction remains low. Similar to the other majorproperty types, the retail market is benefiting fromlimited new construction. Retail construction comple-tions dipped significantly in 2009 and activity wasmuted during 201011 (see Fig. 4.8). Retail vacancyrates have historically tracked very closely to theunemployment rate, which has recently seen one ofits largest drops of the cycle. With the labor marketexpected to continue improving in 2012, recovery inthe retail market should gain momentum. It seemslikely that economies with high employment concen-trations in technology or another expanding driver,such as energy in Texas, will put forth a better show-ing over the next 12 months, but the vast majority ofretail markets are still a long way from a full recovery.


DemandGrowth2010Q3to

2011Q3

Vacancy 2011Q3 (%)

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Dallas

Seattle

Los Angeles

Philadelphia

WashingtonD.C.

New York

Houston

San Diego

Boston

DenverChicago

Riverside

Atlanta

Phoenix

Fort Lauderdale

5 7 9 11 13 15 17 19

Fig.4.10

Metro Retail Market Performance


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Industrial


Source: CBRE-EA

ChangeinSupply/Demand(SF000s)

Vaca

ncy(%)


99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

-100,000

-50,000

0

50,000

100,000

150,000

200,000

250,000

300,000

0

2

4

6

8

10

12

14

Fig.4.11

Industrial FundamentalsFig.4.12

Industrial Demand Drivers

Despite the lackluster job market rebound, all of themajor indicators that influence warehouse demandare rising, including industrial production,consumption, fixed investment, and trade. The indus-trial market posted its fifth straight quarter of fallingvacancy in 3Q 2011 on the heels of solid net absorp-tion and limited new construction. Absorption in 3Q2011 was the strongest since 4Q 2007. Industrialusers finally began to expand their operations aftercontracting in 2008 and 2009 and showing only aslight interest in growth during 2010 (see Fig. 4.11).Preliminary data suggest that this trend continued in

4Q 2011, bringing vacancy down to 13.5%, morethan a full percentage point below its 2Q 2010 peak.

Solid macroeconomic demand drivers such asconsumption and fixed business investment paint afavorable picture for continued growth in industrialdemand. But trade levels have been the most signifi-cant source of optimism (see Fig. 4.12). In particular,the real value of exported goods has reached an all-time high. Part of this increase is driven by surgingfuel exports, which do little to bolster industrialdemand, but broader export growth is clearly having

an influence on the need for space. Consumption andimport growth have shown signs of fading recently,but as job growth continues and the unemploymentrate falls, the U.S. consumer is expected to becomemore active. The debt crisis in Europe is one of thegreatest risks to the outlook for these industrialdemand drivers. If there is a pronounced dip in theEuropean economy, demand for U.S. goods willsuffer and exports will decline.

Industrial market performance at the metro levelvaries greatly (see Fig. 4.13). Trade flows and

increased consumption have bolstered demand atmajor distribution hubs such as Northern New Jersey,Atlanta, and Dallas/Fort Worth. San Joses industrialdemand posted a solid showing over the past year,largely on the back of growing technologycompanies. Demand in the Midwest generallyappears to be languishing but the resurgent autoindustry has given Detroit a lift, although the marketsvacancy rate remains very high. Cincinnati was one ofa very few U.S. industrial markets that saw decliningdemand for space year-over-year as of 3Q 2011. Withthe housing market still weak, markets that depend

Source: Moody's Analytics, Bureau of Economic Analysis

Index(20

07Q4=100)

Exports (Goods)Imports (Goods)Fixed InvestmentConsumption (Goods)

65

70

75

80

85

90

95

100

105

110

115

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011


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on local population growth and home construction todrive the need for warehouse space should be slowto recover. However, markets with the infrastructureto tap into international trade flows and those withinnovative technology economies should continue todo well.

Final data are expected to show industrial rents fellslightly in 2011, but steady improvement in vacancy isforecast through 2015 as new supply remains at verymanageable levels (see Fig. 4.11) and rents areexpected to begin rising again in 2012. There are sig-

nificant risks to this outlook, primarily due to theongoing crisis in Europe. If Europe dips into anotherrecession, trade flows are certain to reverse much oftheir recent gains. Additionally, a double-diprecession would likely be unavoidable in the U.S. ifEuropean economies contract significantly anddemand for goods produced in the U.S. declinessharply. Keeping these significant risks in mind, theindustrial market is poised for continued recoveryincluding the resumption of rent growth in manymetro areas in 2012.




DemandGr

owth2010Q3to2011Q3

Vacancy 2011Q3 (%)

Cincinnati

Los Angeles

EdisorFort

Worth

Atlanta

DetroitDallas

Philadelphia

HoustonNewark

Baltimore

San Jose

Minneapolis

Chicago

Boston

Washington D.C.

5 7 9 11 13 15 17 19 21

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Fig.4.13

Metro Industrial Market Performance


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Bentall Kennedy GroupBentall Kennedy serves the interests of more than 500 clientsacross 142 million square feet of office, retail, industrial, residen-tial and hotel properties totaling in excess of $26 billionthroughout Canada and the US. Widely recognized as a highlydisciplined fiduciary, Bentall Kennedy acts for prominent publicand private pension funds, life insurance companies,endowments, foundations, trusts, high net worth families andsov

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