real estate market report fall 2012

CES ATLANTA / CINCINNATI / DENVER / HOUSTON

ATLANTA OFFICE CINCINNATI OFFICE DENVER OFFICE HOUSTON OFFICE 678.580.6100 (O) 678.580.6200 (O) 678.580.6180 (O) 678.580.6190 (O) [email protected] [email protected] [email protected] [email protected]

Real Estate Market Report – Fall 2012

Real Estate Market Report – Fall 2012 CES

Fall 2012 Page 1 ©2009‐2012 Collateral Evaluation Services, Inc. Real Estate Market Report is compiled and produced by Collateral Evaluation Services, Inc. Readers are advised that Collateral Evaluation Services, Inc. does not represent the data contained herein to be definitive. Neither should the contents of this publication be construed as recommendation on policies or actions. Quotation is permitted with credit to Collateral Evaluation Services, Inc. Please address inquiries to Editor, Real Estate Market Report, 955 Country Club Drive, Cincinnati, OH 45245. Phone: 678.580.6200. Email: GMann@CES‐WM.Com

Letter from the Managing Directors

Dear Reader:

Collateral Evaluation Services, Inc. is pleased to present the Fall 2012 edition of our Real Estate Market Report. As always, we welcome our new readers. This issue, and past issues, can be found on our website at www.ces‐wm.com. If you would like to be removed from our distribution list, please email George Mann at the address below.

If you know of anyone who might be interested in receiving our market report, please feel free to pass this copy along to them. If someone wants to subscribe, they can simply send us their email address and we will add them to our distribution list. We do not share our mail list with anyone outside CES.

Readers have asked if our market report can be quoted. Yes. We only request that you give us appropriate recognition.

As always, we hope you find this report interesting, and optimally somehow of use in your everyday job. We believe CES brings a unique perspective of the national real estate markets. Since we review appraisals nationwide, we see market data and analyses from multiple appraisal firms in each market. This gives us a greater supply of market information to analyze than a single appraisal firm can provide. The assimilation of all this information provides the basis for our National Overview contained within this report.

Your comments are always appreciated. Please email them to George Mann at GMann@CES‐WM.Com.

Everyone at CES hopes the remainder of 2012 is prosperous and you have an enjoyable Holiday Season.

Sincerely,

Managing Directors Collateral Evaluation Services, Inc. www.CES‐WM.com



NOTE: Following is a summary of market conditions for major property types with a focus on the past 24 months and the upcoming 12 months. The information within this section provides generalizations on a nationwide basis. Exceptions may exist in a particular market and/or property type.

Key Observations Residential Housing (1‐to‐4 Units)

Housing prices are forecast to ‘bounce along a bottom’ through the end of 2013.

Home sales over the next three years should exceed new supply and therefore absorb the current oversupply.

Residential subdivisions and condo projects with retail prices under $200,000 should experience the greatest demand over the next few years.

Home ownership has declined significantly (almost back to 1980 levels) in this Depression and further decline is expected.

Multi Family

Vacancy rates are at all‐time lows.

CES is voicing early concerns that vacancy rates may actually increase in 2013 and 2014 from current levels.

Market participants need to account for the increased number of houses that will be rental properties going forward.

Industrial

Occupancy should continue to increase with rents also increasing for specific segments; unique opportunities will present themselves as a result of the Panama Canal expansion being completed in 2014.

Although fundamentals are projected to be strong, overall rent growth for this sector is not expected to occur until 2016.

The 4‐quarter moving average of industrial employment growth turned down for the first time since turning positive in late 2010; this is an early sign of weakness that needs to be watched.

Office

Weak for next 1‐2 years due to anemic employment growth. Permanent decline in demand has occurred as the average employee now occupies 160 square feet versus 200‐250 square feet in the past.

National Overview

By Collateral Evaluation Services, Inc.



Relatively strong fundamentals are expected over the next few years, but the Depression was so severe it will take many years before rental increases occur.

Income and value declines can be expected for those properties with 5‐year leases signed in 2007 and the first half of 2008. As these leases come due, rent rates will decline significantly and/or vacancy will increase.

Retail

Weakest of the four main property sectors; Slow improvement forecast over the next five years.

Effective rents are back to 2005 levels.

According to the Urban Land Institute, the online retail market share is now at 10%.

Vacancy for regional malls is at an all‐time high.

Non‐Investor – Owner‐Occupied

An eye should be kept on companies in industries that will be adversely affected by oil prices staying above $100 per barrel and commodity prices being elevated. However, some companies will be in industries that benefit from both of those items.

An increasing number of banks are telling CES that they plan to become more aggressive in selling their OREO properties. This must occur for the CRE market to begin a rebound, but while these properties are being sold, prices will face downward pressure and likely decline further. We are seeing 20%+ price declines from 2011 that might be a result of this occurring.



SINGLE UNIT DWELLINGS

According to Standard & Poor's Case‐Shiller home‐price indexes, U.S. home prices showed their first year‐over‐year increase (1.2%) since 2010 (housing tax credit event). A number of other home price indices are also reflecting their first annual increases in many years.

Nominal prices are currently at their Summer 2003 levels. Real prices are back to 1999‐2000 levels (depending on the index) and, as we have noted before, are also at 1890 levels. To tweak the phrase a house is your single biggest investment, it is safe to say a house is your single largest bad investment. Not too many products can boast a 120‐year record of no real returns! Of course, don’t look for NAR to point this out

“Home prices gained in the second quarter,” says David M. Blitzer, Chairman of the Index Committee at

S&P Dow Jones Indices. “In this month’s report all three composites and all 20 cities improved both in

June and through the entire second quarter of 2012. All 20 cities and both monthly Composites rose for

the second consecutive month. It would have been a third consecutive month had we not seen home

prices fall in Detroit back in April.

“The National Composite rose by 6.9% in the second quarter alone, and is up 1.2% from the same

quarter of 2011. The 10‐ and 20‐City Composites closely mimic these results; the 10‐City was up 5.8%

over the quarter and the 20‐City was up 6.0%. The two Composites also entered positive territory on an

annual basis, up 0.1% and 0.5%, respectively.

“Only two cities – Charlotte and Dallas – saw annual rates of change worsen in June. The other 18 cities

and both composites saw improvement in this statistic, and 13 of these had a positive trend. There

were only six cities – Atlanta, Chicago, Las Vegas, Los Angeles, New York and San Diego – where the

annual rates of change were still negative. Boston‘s annual rate was flat. We seem to be witnessing

exactly what we needed for a sustained recovery; monthly increases coupled with improving annual

rates of change. The market may have finally turned around.

“The regions showed positive results for June. All 20 of the cities saw average home prices rise in June

over May and all were by at least 1.0%. Detroit was up the most, +6.0%, and Charlotte the least, +1.0%.

The Composites showed the same increases as last month – the 10‐City rose by 2.2% in June and the

20‐City by 2.3%. We are aware that we are in the middle of a seasonal buying period, but the combined

positive news coming from both monthly and annual rates of change in home prices bode well for the

housing market.”



The housing market remains sluggish despite affordable prices and interest rates that have been hovering around historic lows. A weak job market, abundant foreclosures and tighter mortgage requirements have continued to weigh on the market.

Another contributing factor to the slow recovery of the housing market stems from the student loans for the now dubbed ‘boomerang generation.’ Named for their return to living at home after graduation, many young adults in this generation are having a hard time getting out on their feet after college, mainly due to inability to find jobs and large amounts of student loan debt. Recent reports indicate current collective student loan debt in the US has surpassed $1 trillion, which is greater than our nation’s total credit card debt.

Saddled with this large amount of student loan debt, these young adults are having a hard time transitioning to independent living after college. Post‐college graduates would normally get a job and move on to purchase starter homes. However, with the difficulty in finding jobs and the instability in the job market, young adults graduating during The Great Depression II are more often moving back in with their parents to save money, pay off debt, and ensure financial stability.

These so‐called ‘boomerangers’ are creating a ripple effect that will impact more than just the housing market. As they are not buying new houses or moving into their own apartments, they are not purchasing home goods first‐time homebuyers typically need. Their hesitation to make investments in houses, home goods, new cars and other products upon getting their first job out of college adds to the slow recovery process.

On a brighter note, The National Association of Realtors reported that sales of previously owned homes in the U.S. rose 10.4% to a seasonally‐adjusted annual rate of 4.47 million in July. Inventory of unsold homes contracted 23% (year‐over‐year) to a level considered healthy by economists (6.4 months). Low inventory is being reported in numerous markets and is being given credit for price stabilization.

Housing futures traded on the Chicago Mercantile Exchange (CME) are projecting a 2% decline in prices thru May 2013. This is likely a reflection of the seasonal trend for house prices to decline in the second half of the year and increase in the first half of the year. Prices are forecast to increase 5%, 4%, and 2% in the three years following the May 2013 low. Over the past few years the futures have been reasonably accurate.

Fundamentals ‐ The weakness in housing is a simple case of excess supply and weak demand. Total annual demand for housing is about 1.4 million units. This is based on the national population increasing 2.7 million each year and around 200,000 dwellings being demolished each year. Recent housing construction has averaged 500,000 units per year. With demand exceeding supply for the next 1‐2+ years, the current oversupply will diminish and a firmer market should exist around 2013‐2014.



FORECAST

Our forecast is in line with the CME futures – prices are bouncing along the bottom. Prices will be under pressure in those areas where more foreclosures are brought to market. However, this should be offset by those markets experiencing some strength.

New loans on purchases of rental properties should be looked at very closely as price appreciation does not appear to be likely in the foreseeable future. Also, with investors purchasing large quantities of houses to rent, there is likely to be an abundance of supply unlike anything we have seen in the past. This will put downward pressure on rent levels.

HEDGE FUND/PRIVATE EQUITY PARTICIPANTS

Before we move onto other property types, we wanted to address the new phenomenon of hedge funds buying billions of dollars of houses with the sole intent of renting them. Their reasoning is the great return they are getting – assumed to be in the 8%‐10% range.

Of course, we believe this is a poor investment that will come back to haunt these investors. Several reasons come to mind:

A large volume of foreclosed homes probably indicates that market is inherently weak

Apartment management has significant superior efficiency – would you rather manage 200 rental units at one location or 200 houses spread over a dozen cities with probably no more than 2 or 3 houses even remotely close to each other?

Apartment complexes have lower expenses – economies of scale can be achieved for maintenance, administration, marketing, and even real estate taxes are lower per unit

Real appreciation for housing has been zero for 120 years – there is no upside for these houses in general, much less when located in below average markets

Most importantly, the same demand problem exists regardless of the owner – the huge volume of vacant houses nationwide is due to too many units being built. i.e. Supply far exceeds demand. We have decades of excess supply – whether a household owns or rents, they just need one unit. Just because investors buy a house doesn’t mean there is a demand for it.

Luckily, most of these large investors pay all cash and banks are not lending to them. We would recommend banks be extremely cautious if approached to lend on huge portfolios of rental homes. The local borrower with 5 or 20 or 40 rental homes remains your best target for this property niche.



VACANT LAND, RESIDENTIAL SUBDIVISIONS, & CONDOMINIUM PROJECTS

In general, as long as the housing market remains weak these property types will exhibit sustained weakness. Project values are very specific to the local market as nearby projects greatly influence a property’s retail price and sales rate.

Discount rates are a general item that can be applied to local properties. IRRs in the PwC Real Estate Investor Survey (aka The Korpacz Survey) average 20.25%, but correspond to projects with a 9‐year sellout period. Projects with shorter sellout periods have discount rates approaching 30%. The latest data available was as of 4th Quarter 2011.

RealtyRates has the most comprehensive survey of discount rates. For those using this survey (the only survey we know of nationwide that covers residential subdivisions and condo projects), note that the discount rates for residential lots include entrepreneurial profit. However, the discount rates for condo projects do not include profit. A 12% to 15% line item deduction must be made in addition to the discount rate in the survey.

The 2nd Quarter 2012 RealtyRates Developer Survey (1st Quarter 2012 data) shows the national average discount rate for residential subdivisions is 36.39%. This is up from 35.62% in the prior quarter. The national average condo project discount rate is 21.20% up from 21.02% in the previous quarter, exclusive of entrepreneurial profit as noted above.

Forecast

According to an economist at Wells Fargo, the median affordable home price today is $185,000. As such, projects priced around this level are most likely to see reasonable sales activity. High priced projects and second home projects are expected to remain very weak over the next few years. The market for finished lots may begin to improve in stronger markets where the number of foreclosures is low and available inventory of improved houses is also low.

COMMERCIAL PROPERTIES – Income Producing

The Moody’s/RCA National All‐Property Composite Index measured a 0.5% increase in June. The index is up 10.3% from a year earlier, but 21.3% below the December 2007 peak. Prices are currently at 2005 levels.

NOTE: MIT became involved with this index earlier this year. As a result, the indices have changed. The new figures show prices bottoming in 2009 and increasing steadily since then. Per the graph below, this was not the case before MIT changed the data. The new data appears to deal with investment‐grade properties and this sector has been much stronger than the remaining 99% of the market. As such, we will stop reporting on this index as it no longer reflects the market most of us deal with on a daily basis.



The Quiet Drop in Values

Our clients have us write a summary document any time a new appraisal comes in with a value at least 20% lower than the appraisal in 2011. This is occurring on a frequent basis across the nation and across all property types. However, we are not reading any reports of a significant decline in CRE values in the past year. In fact, the above discussion shows reports of double‐digit appreciation.

We are reviewing actual appraisals on the same exact properties usually done by the same appraisers (not always…sometimes the appraiser changes from year to year). This data is a lot more accurate than an accumulation of unverified sales prices used in national indices.

If you have appraised a property before, we would recommend you take a few minutes to see how the values compare. We would appreciate feedback on what you are seeing – are your values down, about the same, or up? Does property type matter? Please email George Mann (GMann@CES‐WM.Com) with such information and if we get enough feedback we’ll report on it in the next issue.

Before we leave the topic, the reason for the declines is readily apparent in the appraisals we review. Since the 2011 appraisals, a number of new sales have occurred and an abundance of those are bank OREO properties. Some will argue that this proves these sales are below market and should not be used. However, having worked in banks for numerous decades we know that the workout people get incentive pay to achieve prices above recent appraisals and they almost always do. In our opinion,



OREO sales are rarely below market. We believe the fall in prices is due to increased supply when demand is still very low. In such markets it doesn’t take much to make prices decline.

Cap Rates

We continue to review appraisals that quote the institutional‐grade cap rates in the PwC Real Estate Investor Survey while appraising non‐institutional grade properties. As a reminder, cap rates for non‐institutional grade properties as of the 2nd Quarter 2012 Survey (4th Quarter 2011 Data) were as follows:

PROPERTY TYPE AVERAGE CAP RATE

APARTMENTS 7.32%

WAREHOUSE BUILDINGS 9.21%

MEDICAL OFFICE BUILDINGS 9.20%

SUBURBAN OFFICE BUILDINGS 9.04%

STRIP SHOPPING CENTERS 9.74%

SOURCE: 4th Quarter 2011 PwC Real Estate Investor Survey

The above cap rates have declined about 50‐100bp from a year earlier and 0‐50bp from six months ago.

Cap rates are forecast to remain steady this year. Albeit, if interest rates begin to tick up and then mortgage rates increase, we might see a surprise increase in cap rates. However, the chance of a surprise increase in market rates has become slim with the Federal Reserve guaranteeing low interest rates into 2014. The September 13th FOMC meeting may see this extended into 2015.

Remember that the cap rates you hear quoted in the press are for investment grade properties. Cap rates for the other 99% of the properties most of us deal with are not quoted in the press and they likely won’t follow investment grade cap rates downward.

Our discussion of the various property types follows.

Apartments

Fundamentals turned around sharply in 2010 and continue to be very positive. According to REIS, Inc., the national vacancy rate dropped from a record high of 8.0% at the end of 2009 to the current record low of 4.7% (2nd Quarter 2012). Vacancy is projected to decline to 4.3% by yearend and remain between 4.1% and 4.2% through 2016. Effective rent is growing at about a 5% annual rate and that is also projected through 2016.



Although the national forecast is positive, weakness is likely to continue for older Class B properties and markets with double‐digit vacancy rates (Source: IRR‐Viewpoint 2012) – Columbia (SC), Houston, and Sarasota (9.5% vacancy).

Until recently, the fundamentals looked positive through 2013 and into 2014. However, we believe forecasters are projecting the atypical demand in 2010 into the future and that is not supported by household growth. As such, we forecast national vacancy to be 4.9% at Yearend 2013 and 6.0% at Yearend 2014. Rental growth would probably slow to the 3%‐4% annual range.

Rents have been strongest for Class A projects and this is projected to continue into 2013. Class B and C projects have not fared as well with increasing rents and this too is projected to be the case into 2013. With cap rates forecast to hold steady, values should increase in line with rents.

A new supply‐side factor has evolved in the rental market and this needs to be considered by appraisers, investors, and lenders going forward – i.e. the large number of houses that will be rental properties going forward. In the past, market analysts typically ignored the number of houses being rented. The number wasn’t significant and other factors probably offset it.

However, it is public knowledge that hedge funds/private equity have been buying billions of dollars of houses with plans to rent them for years to come. The most likely product they can buy in bulk is foreclosed homes. Therefore, it is markets with a large volume of foreclosed homes that the typical apartment complex will now compete with houses for tenants. The number of people renting (i.e. demand) will remain the same (these people have been renting since 2008‐2011 when they lost their homes), but now the number of rental units (i.e. supply) will include the typical apartment complex plus a large number of houses. According to the American Community Survey (ACS), the number of renter‐occupied single‐family detached homes is 2.1 million higher than it was in 2006.

We have seen recent surveys of families that rent and the vast majority indicate they would prefer to rent a house over an apartment unit. Maybe this factor will attribute to the unexpected rise in vacancy for apartment complexes that we are forecasting.

Industrial

Employment sectors that drive Industrial demand lost over 2.7 million jobs in 2009. However, in each of the years 2010 and 2011 employment increased by almost 500,000 jobs. Moody’s Economy.com forecasts slow industrial employment growth in 2012 and 2013 followed by more rapid growth from 2014‐2016.

From a historical perspective, these employment sectors turned negative (i.e. net job losses) in the 4th Quarter of 2007. Employment growth generally leads absorption by six months – in fact, industrial absorption turned negative in the 2nd Quarter of 2008.

The table below shows that the last four quarters have seen an average gain of 142,000 jobs in industrial sectors. The 4‐quarter average almost turned positive in the 3rd Quarter of 2010 and



subsequently the national industrial market has experienced positive absorption since the 1st Quarter of 2011.

INDUSTRIAL SECTOR EMPLOYMENT – NATIONWIDE

Year

2011 2012

Quarter 1st QTR 2nd QTR 3rd QTR 4th QTR 1st QTR 2nd QTR

Quarter Δ * (Change)

+180 +209 +96 +170 +198 +105

Four (4)‐Qtr. Avg. * +129 +149 +158 +164 +168 +142

* ‐ In Thousands. SOURCE: Department of Labor, Bureau of Labor Statistics

According to Grubb & Ellis, national vacancy ended 2011 at 9.5%, down from 10.4% a year earlier. They forecast vacancy will decrease to 8.7% by the end of 2012. Although fundamentals are very strong, rent growth has been difficult to come by. In fact, some participants call for strong fundamentals for years to come but no rent growth until 2016.

As with the Apartment sector, various segments are performing quite differently. Class A distribution space and large blocks of logistic space have been and should continue to outperform other segments. Smaller, second‐generation warehouse space is underperforming despite significant rent concessions being offered. This is likely attributed to weak confidence in the small business community. We concur with Grubb & Ellis that overall vacancy should decline. Rent growth will be very specific to the segment and property location.

As an aside, market participants have begun to consider how the Panama Canal expansion to be completed in 2014 will affect distribution patterns. Also, China is proposing a ‘land canal’ (i.e. a railway) across Columbia to rival the Panama Canal. For those good at reading tea leaves, there will be some unique opportunities in this property sector this decade. Houston and Tampa are already expanding their ports and planning large intermodal facilities. New Panamax is the name of the new vessels that will be able to go thru the larger third lane of locks in 2014. It is worth checking out Wikipedia or such to learn about the upcoming changes to the Panama Canal.

Office

According to Grubb & Ellis, national vacancy was at 16.8% as of year‐end 2011, down from 17.8% a year earlier. REIS, Inc. indicated a 17.3% vacancy rate as of yearend 2011, down from 17.6% a year earlier. These vacancy rates are near 18‐year highs. Also according to REIS, Inc., effective rents have increased 1.65% from a year ago. According to Grubb & Ellis, Class A rents were flat and Class B rents were down about 1% from a year ago.



Grubb & Ellis is forecasting a vacancy decrease in 2012 to 15.7% and asking rent increases of 1% for Class A space and no increase for Class B space. REIS, Inc. is forecasting a vacancy decrease to 17.0% and asking rent increases of 1.9% in 2012, with vacancy decreasing to 14.0% by 2016 and rents increasing between 3.5%‐5% per year through 2016. As of 2nd Quarter 2012, REIS, Inc. reports vacancy at 17.2% and rents up 0.9% YTD.

The Nation lost 8.8 million jobs in The Great Depression II. Reportedly 4.5 million jobs have been gained since the bottom. Forecasts call for 1.8 million jobs being created in 2012, down from 2.1 million jobs created in 2011. Due to this relatively slow growth (compared to historical recessionary downturns and rebounds) economists project ‘full employment’ will not occur until sometime between 2014 and 2017. Economists are also forecasting 6.5%‐7.5% unemployment to be the new ‘normal.’ This would be up from the historic average of 5.7% experienced since 1948.

A lower level of ‘full employment’ results in a permanent reduction in the demand for office (as well as industrial) space. Also, recent studies suggest the average office employee now occupies 160 square feet versus 200‐250 square feet in the past. This is another significant and permanent decline in the demand for office space in all markets.

This property type is typically the last to recover and it looks like weakness will prevail for 1‐2 more years. REIS has reduced its 5‐year vacancy forecast from 15% to 14%. This is becoming more in line with CES’ forecast that employment will increase faster than others are projecting in the later years and vacancy should decline to 12% five years out.

Retail

Yearend 2011 vacancy was 11.0%, unchanged from a year earlier (Source: REIS, Inc.). REIS, Inc. projects vacancy to decline to 10.7% by yearend and effective rents to increase by 0.7%. With consumer confidence still low and housing prices weak, we agree with REIS that 2012 won’t be too rosy for retailers. We also agree with their 5‐year forecast for gradual improvement thru 2016. Annual rent growth will start off slow but may increase to between 3% per year by 2015.

FORECAST

Overall, we rate the property types from strongest to weakest as – Apartments, Industrial, Office, and Retail. However, unlike 2008‐2010 when almost all cities moved in the same direction, location once again becomes important. For example, Apartments may be strong in general, but there are some weak locations. Areas where it is difficult to add supply (e.g. New York, Washington DC) are performing the best. As each sector recovers, the degree of improvement will vary by city and property class. The only significant change from last issue is that we are forecasting the Apartment sector to be weaker (or maybe the better term is ‘less strong’) in 2013 and 2014 than most participants are forecasting.



COMMERCIAL PROPERTIES – Owner Occupied

News stories make it clear that the current economic slowdown is attributable to concerns about the Eurozone and uncertainty about the upcoming Election and Fiscal Cliff. This is supported by the latest National Federation of Independent Business (NFIB) survey:

WASHINGTON, D.C., August 22, 2012 — Small‐business owners prominently rank “Uncertainty Over Economic Conditions” and “Uncertainty Over Government Actions” as their second and fourth most serious problems in the quadrennial National Federation of Independent Business (NFIB) report, Problems and Priorities. The top problem remains “Cost of Health Insurance,” which has historically been the No. 1 problem for small employers; 52 percent labeled it as “critical”. Nearly 40 percent of those surveyed said that economic uncertainty is the most critical problem, followed by 35 percent who identified “Energy Costs, Except Electricity” as critical for their firms; another 35 percent of owners named “Uncertainty Over Government Actions” as their most critical issue.

“This year’s survey was conducted on the heels of the worst U.S. recession since the 1930s; historically high levels of unemployment and housing foreclosures, and historically low levels of consumer confidence and hiring still plague the small‐business community,” said Holly Wade, senior policy analyst and survey author. “The high level of uncertainty cited by small employers helps to explain the sector’s inability to recover and expand. Fears over increasing health insurance costs continue to dominate the list of concerns for small businesses, very much in spite of the president’s health insurance reform law—certainly not an endorsement of the policy, nor a good sign for the future of the sector.”

As we have pointed out in prior issues, banks should not be accused of not lending to small business or any other sector. The fact is small businesses have minimal desire for credit at this time.

The only advice we have at this time is for banks to continue their normal diligence in analyzing the operating performance of their small business borrowers. Credit departments already know the red flags to look for in a business that is just starting to have problems.

COMMERCIAL PROPERTIES – Vacant Land

Commercial land did not have the bubble that the residential land market experienced. Many of the appraisals that we review show declines up to 50% have occurred in some markets. This looks to be attributable to market participants discounting values for a holding period of 2 to 5 years before development becomes feasible again. Market participants are discounting commercial land 12%‐20% annually (we use 15%‐20% in our analyses) for the holding period until development is feasible.

The most significant price declines have been in locations where market participants paid premiums for ‘entitled’ properties. These areas are finding that these ‘entitlements’ are being valued at $0 today and thus significant value declines are occurring. This is more attributable to the ‘bubble’ mentality that paid outrageous prices for an entitlement that might have cost a few thousand dollars to obtain. We have seen several properties that were sold at 1500%+ price increases between 2003 and 2006 only to experience 90%+ value declines as the entire entitlement premium vanishes.

Similar price increases and decreases have also occurred for the parcel of agricultural land that became a potential subdivision only to become agricultural land again today. This is a common scenario we see in many areas of the country. Basically, this shows that the Highest & Best Use of a



property can change as market conditions change. Price increases of 500% can be taken away with price declines of 95%.

It should be a few decades (hopefully! Note: George Mann’s forecast for the next bubble to occur is 2027‐2032) before we encounter this problem again – maybe by then we will have figured out a way to avoid the extreme price and value fluctuations.



Mann’s Take On Things

By George R. Mann, MAI, SRA, MRICS

“Forecasting the Bottom”

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” – John Mills, December 11, 1867 in an article

titled Credit Cycles and the Origin of Commercial Panics

CYCLES

Seven years ago this Summer I personally declared The Great Depression II was beginning. Albeit, that was with regard to real estate markets only.

Looking back, we are twelve years into the financial bear market. The NASDAQ peaked in early 2000 when the dot.com bubble burst. In real terms (i.e. measured against the CRB, gold, or PPI), the Dow Jones Industrial Average peaked in 1999 and early 2000. When can we expect the final bottom in this Depression to occur?

Ever since I started following the markets as a kid it was apparent that a 16‐18 year cycle dominated the ebb and flow of stocks. The Dow peaked in real terms at just over 1,000 in 1966. A sideways trend followed with the final bottom occurring at 777 in August 1982. This 16‐year cycle was followed by The Great Bull Market that peaked in 1999/2000, per above. Therefore, based on this cycle, I am expecting the next bottom to occur between 2016 and 2018.

Market participants are starting to recognize an uncanny resemblance between the 1966‐1982 cycle and the current 2000‐201x cycle. The Dow’s real high occurred at 1,000 in 1966 and was followed by a nominal high of 1,051 in January 1973. This time around the Dow’s real high was 11,908 on January 14, 2000, followed by a nominal high of 14,164 on October 9, 2007. Coincidentally, the time between highs was seven years in both cycles. Also, the Dow bottomed at 577 in December 1974. The most recent Dow low was 6,443 in March 2009. These extreme lows occurred about 18‐24 months after the nominal highs.

As noted above, looking at the Dow from 1966 to 1982 and from 2000 to 2012 the charts look very similar. History doesn’t repeat itself exactly, but it certainly does repeat itself. If this long‐term cycle follows suit, a final Dow low should occur in the year 2016. Also, this low will not be below the March 2009 low. This makes sense as the Fed continues to print money and inflate prices on a nominal basis.

A financial service I have followed since college (The Elliott Wave Theorist – www.elliottwave.com) said it takes about ten years for people to get their debt situation sorted out after a bubble has burst. Ten years out from the beginning of this credit crisis in the Fall of 2008 puts us in the year 2018. Thus, as I noted above, I am expecting an end to The Second Great Depression around 2016 to 2018.



POLAND

Why does the 16‐18 year cycle discuss above occur? My belief is it relates to the ebb and flow of generations of population. It had to be easy to predict the 1982‐2000 Bull Market would occur simply because of the huge Baby Boomer population that would be entering their prime income, and therefore investment, years. The subsequent decline from 2000 to 2016/2018 was obvious as the Baby Boomer generation began to leave the workforce and choose safer investments for their retirement years.

Which leads us to Poland. About five years ago, I came across a demographic graph for Poland and it looked like the American graph before the Baby Boomers entered their prime income years. Therefore, I forecast that Poland would be the place to invest for the next 10‐20 years. Since 2008, Poland is the only European country other than Germany to have positive GDP growth. For those into international investing, Poland should be on your radar.

THE ELECTION

As I have mentioned here for the past 18 months, I believe it is a sure thing that Obama gets re‐elected (and yes I have been wrong before). Therefore, I have not wasted much time worrying about the results or what might happen differently if Mr. Romney won. Either way, as a Bloomberg article this week concluded, our debt will continue to spiral out of control – the world depends on that to happen, else a major crisis will occur. Neither Obama nor Romney will halt the exponential growth in debt. Both are convinced economic growth is needed to make the populace happy. Too bad they won’t follow the lead of Iceland, Ireland, Greece, Portugal, and Spain and implement an extreme austerity program. Iceland and Ireland are already seeing economic revival as they have suffered the pain of their excesses and are now moving forward. Instead the USA will continue its economic misery due to a program of extend and pretend. I am certainly in the minority with my philosophy of austerity before growth.

Forget about the election and worry more about the ‘Fiscal Cliff’ on January 1, 2013. That event has already greatly influenced our economy (negatively as companies are not making major decisions in advance of that date) and will affect our economy in 2013 more than Obama or Romney can. Will a lame‐duck Congress make a bipartisan decision? That might be a mute question as this date could get pushed back beyond the Inauguration and the new Congress might deal with this event. I recall the Treasury being able to delay our default event in 2011 by a month or two by cutting some expenses.

The above is a ‘Known Unknown’ as Donald Rumsfield would term it. As markets account for events six months into the future, it looks like there is no concern about the ‘Fiscal Cliff.’ Hopefully, the smart money is right this time. The ‘Unknown Unknowns’ are the events that surprise us all and cause significant market fluctuations. Nowadays, these are called Black Swan events.

TERMS & STATS

The Great Depression II has brought us a number of new phrases – Quantitative Easing (QE1, QE2, and the soon to be started QE3), Austerity, Bifurcation, et al. I will leave you with future phrases to be aware of and research on your own as you have time – Parabolic Curves (basically what goes up must come down and this type of graph always ends in disaster as prices go all the way back to where they started), Peak Oil, Factory Farms, Peak Food, Crediticism (replaced Capitalism that ended back in the 1960’s), and Slowcovery.



An acronym I found interesting is EROEI – Energy Return on Energy Invested. In 1930, it only took one barrel of oil to produce 100 barrels of oil. Today we only get 3 barrels of oil out of that one barrel invested. This trend will continue to worsen and thus the price of oil has to go up…and up….and up. Natural Gas has an EROEI of 15:1 (versus 3:1 for oil noted above). Solar and water also have very high EROEIs. Ethanol has a negative EROEI! We can lessen our dependence on oil, but how long will that take. It took 100 years for coal to overtake horse power and 100 years for oil to overtake coal (occurred in 1964). I don’t think we can wait ‘til 2064 for natural gas (or a combination of natural gas, water, and solar) to overtake oil. But, is there even a small chance of this occurring in the next 10 or 20 years?

Interesting stats for this issue are as follows:

It takes 1,000 tons of water to make 1 ton of wheat!

A major aquifer (the Ogallala in the Midwest USA) is predicted to run dry in 25 years – luckily it only takes 6,000 years to refill an aquifer.

In 1990, I predicted that wars of the future would be over water, not oil. I was a bit early, but the next 5‐10 years may regretfully bring this to reality. Reportedly, there is a finite amount of water on Earth – 360 quintillion gallons to be exact. In the past ten years, global demand for water increased 58%. When supply is fixed and demand is increasing, we all know what happens to prices. Also, when supply is fixed and it does not meet the demand of your country, we can assume that country will do something to obtain the water it now needs.

WHATEVER HAPPENED TO LEADERSHIP WITH MORALS & ETHICS

Whether it is a coach of a sports team or the CEO of a company, people know the troops will reflect the morals and ethics of their leader. I was lucky enough to start my banking career in 1992 at Crestar Bank. Richard Tilghman was the CEO at the time. His high standard of ethics flowed down throughout the entire company. It was a pleasure to work at a bank where I can honestly say I never saw shortcuts being taken, senior management didn’t ask ‘How can we get around this law?’ (as occurred at another company I worked for), and you could respect all your co‐workers as you saw them doing their best to compete in an honest and ethical manner.

Greg Donaldson of Donaldson Capital Management in Evansville, Indiana is quoted in Bloomberg Businessweek (August 27 – September 2, 2012) as saying “The banks have no moral authority at the moment.” Out of 7,400 banks nationwide, we know that the vast majority of leaders are ethical and do all they possibly can to support their local communities. As with any industry, it is the few bad apples that negatively affect the reputation of everyone else.

Which leads me to this edition’s game of ‘Who Am I?’ Following are the headlines for a particular CEO’s company for the past ten years:

“In December 2002, XYZ paid fines totaling $80 million…for deceiving investors with biased research.”

“In 2003, XYZ paid $160 million in fines and penalties to the SEC for its role in Enron.”

“In 2005, XYZ paid $2.2 billion to settle a lawsuit by investors of Enron.”

“In 2005, XYZ paid $2 billion to investors of WorldCom – they could have settled for $630 million less in 2004, but decided to fight this battle.”

“In November 2009, XYZ paid $722 million to settle with the SEC in regard to a derivatives probe.”



“In June 2010, XYZ was fined a record $49 million by the UK’s FSA for failing to protect clients’ money from 2002 to 2009.”

“In April 2011, XYZ paid $27 million to settle a class‐action suit for overcharging military personnel and the CEO apologized to shareholders.”

“In 2012, XYZ loses $5.8 billion on a credit derivatives trade and again the CEO apologizes to shareholders.”

Could any of you imagine being in a job and having any one of the above items occur and you not be escorted right out the door ASAP? If you were coaching a sports team and you had ethical violation after ethical violation occurring on your watch, do you think you would still have a job?

The bottom line is corporations need to hold their leadership accountable and show the public (shareholders yes, but the public is even more important so as to regain trust) they will not tolerate significant indiscretions (accidents and errors happen obviously….but a trail like that above over a period of ten years is not a one‐time error….the ‘losses’ above total $11 billion!). Peers at other corporations need to demand leadership be cleaned up across the board – regaining public trust will help everyone.

Thankfully, many companies have changed leadership and are trying to clean up their image. Regretfully, we have several more companies that need to do the same so public trust can be restored.

As we get ready to send this report out, a headline today in the Financial Times says ‘XYZ Faces Fresh Probe.’ And the unethical behavior goes on…

SMALLER GOVERNMENT AND LOWER UNEMPLOYMENT CANNOT OCCUR TOGETHER

I find it amusing that the same people who want smaller government complain about unemployment being too high. How exactly do we layoff government workers AND keep unemployment from going up?

State and local government lost 129,000 jobs in 2009, 262,000 in 2010, and 230,000 in 2011. Federal government has lost 43,000 jobs in the past twelve months. Over 650,000 of our fellow neighbors have lost their government jobs. This can only increase the unemployment rate.

So far I haven’t heard The Tea Party give the current administration credit for aggressively shrinking the size of government. I am not holding my breath.

BLOG

Soon CES will have a revamped web site. When that occurs, I will be rolling out a blog titled ‘Mann Overboard.’ I believe there is enough information that comes out daily to make an active blog possible. We will let you know when this goes live.

Until the next issue, stay well and safe travels to all….



COLLATERAL EVALUATION SERVICES, INC. 590 Colonial Park Drive Roswell, GA 30075

George R. Mann, MAI, SRA, MRICS 678.580.6200 gmann@ces‐wm.com Larry R. Woodall, CGA 678.580.6100 lwoodall@ces‐wm.com Robert S. Ely, CGA 678.580.6180 rely@ces‐wm.com

Simone Johnson 678.580.6120 sjohnson@ces‐wm.com Matt Turner 678.580.6130 mturner@ces‐wm.com

WWW.CES‐WM.COM

real estate market report fall 2012

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