Commercial real estate outlook
August 2009
Ben Breslau
Senior Vice President
Director of Research
Agenda
Financial crisis and economic recession
Property fundamentals
Capital markets trends
Strategy implications
Real estate outlook
2
Financial crisis
and recession
3
The Economic Cycle
What causes the boom?
History lesson – irrational capital flows - $$$$
1990 – Unsophisticated direct real estate debt investment binge
• Expectation of continued high inflation
• 110% loan to value (LTV) from Savings and Loans seeking fees and returns
• Zero equity speculative development with no underwriting discipline
• Financing and tax loopholes spurred substantial excess development
• Result – government solution - RTC (Resolution Trust Corporation)
• 5+ year real estate depression – high vacancy, low rents and values
• Birth of REIT and securitized debt markets
2000 – Dot.com boom and unbridled capital flows to tech, VC, and IPOs
• Increased equity, more sophisticated debt, and much less spec development
• Boom came on the demand side –Cambridge vacancy in 1999-2000 = 1%
• Rents and values increased dramatically from NOI growth
• Preleased new construction from excess demand
• Result – jobless recovery – high vacancy, low rents and values
• Very limited (relatively) distress for commercial real estate investors
5
What caused this boom and bust?
History lesson – irrational capital flows - $$$$
2005-2007 – Easy credit debt boom, securitization, and sloppy underwriting
• Equity returned and limited excess speculative development
• Securitization took CRE debt and equity to public markets
• The industry shifted from creating wealth by adding value to the property to a
focus on financial engineering and expectation of endless gains
• Low interest rates and abundant global liquidity enabled borrowers to highly
leverage properties with very inexpensive (i.e. priced for no risk) capital
• Wall Street fueled the fire and became a conduit machine
• Rent and values increase from investor “pull” – Blackstone effect
• Public markets increased information flow and transparency but ultimate
investors were blind to the risks
• Rating agencies and government regulators failed
• Result – housing bubble bursting cut off all lending to nearly every sector
including CRE which remains in a credit vacuum
• Credit crunch ripple effects led to economic recession that further deteriorates
property fundamentals
6
Debt-to-GDP Ratio
1.25
1.5
1.75
2
2.25
2.5
2.75
3
3.25
3.5
3.75
19 5
3Q
1
19 5
5Q
1
19 5
7Q
1
19 5
9Q
1
19 6
1Q
1
19 6
3Q
1
19 6
5Q
1
19 6
7Q
1
19 6
9Q
1
19 7
1Q
1
19 7
Debt-to-GDP Ratio
3Q
1
19 7
Source: Jones Lang LaSalle, Moody’s Economy.com, Federal Reserve
5Q
1
19 7
7Q
1
19 7
9Q
1
19 8
1Q
1
19 8
3Q
1
19 8
5Q
1
19 8
7Q
Low interest rates fueled an unsustainable trend
1
19 8
9Q
1
19 9
1Q
1
19 9
3Q
1
19 9
5Q
1
19 9
7Q
1
19 9
9Q
1
A long-overdue economy-wide de-leveraging
20 0
1Q
1
20 0
3Q
1
20 0
5Q
1
20 0
7Q
1
20 0
9Q
1
Home Price/Household Income
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
1 9 80 Q
1
1 9 81 Q
1
1 9 82 Q
1
1 9 83 Q
1
1 9 84 Q
1
1 9 85 Q
1
1 9 86 Q
1
1 9 87 Q
1
Source: Jones Lang LaSalle, Moody’s Economy.com
1 9 88 Q
1
1 9 89 Q
1
1 9 90 Q
1
1 9 91 Q
1
1 9 92 Q
1
1 9 93 Q
1
1 9 94 Q
1
1 9 95 Q
1
1 9 96 Q
1
1 9 97 Q
1
1 9 98 Q
1
1 9 99 Q
1
2004-2006
Price correction triggers massive wealth destruction
Price Bubble,
2 0 00 Q
1
Peak of Home
2 0 01 Q
1
2 0 02 Q
1
2 0 03 Q
1
2 0 04 Q
1
average
2 0 05 Q
1
2 0 06 Q
1
below long-term
U.S. housing market bubble – of epic proportions
2 0 07 Q
1
Ratio heading far
1979-2001 Average
2 0 08 Q
1
2 0 09 Q
1
Pr
oje
ted c
US consumers – recovering from a decade long binge
Balance sheet correction underway, but spending will remain depressed
8
Personal net flows as % of GDP
6
Sustained high
savings rate likely
4
2
0
-2
-4
-6
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 '00 '02 '04 '06 '08 '10
Source: U.S. Census Bureau, High Frequency Economics
9
Wave of loan losses and deteriorating economy caused
banking crisis and crisis of confidence
Commercial bank two-year loan loss rate
12
10
Estimated losses 2009 and 2010
8
•Baseline loss rate = 5.1%
6
Rate %
•Adverse scenario loss rate = 9.1%
4
2
0
-2
'2 2
'2 6
'3 0
'3 4
'3 8
'4 2
'4 6
'5 0
'5 4
'5 8
'6 1
'6 6
'7 0
'7 4
'7 8
'8 2
'8 6
'9 0
'9 4
'9 8
'0 2
'0 6
'1 0
Source: Moody’s Economy.com, Jones Lang LaSalle
Staggering scale of “bad asset” problem
Expected total losses on Debt Assets: $2.6 trillion and counting
1,400 Residential Mortgages
1,200
1,000
Projected Losses, $ Billions
800
Corporate
600
Loans Commercial Mortgages
400 Consumer
Loans
200
0
Source: Moody’s Economy.com, Jones Lang LaSalle
• 49% of losses projected to be borne by banks, 37% by other
financial firms and the balance by the government
US Commercial Bank Failures
# of bank failures per year
300
250
200 1,500 bank failures between 100 banks
82 and 93 could fail
in 2009
150
25 failed
100
banks in
2008
50
0
36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 '00 '04 '08
Source: FDIC: Historical Statistics on Banking
Month 00, 2002 12
Consequences for banks
Economic contraction now 18 months old
GDP contracted by 1.0 percent in the second quarter
8.0%
Quarterly percent decline
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
Q1 2000
Q3 2000
Q1 2001
Q3 2001
Q1 2001
Q3 2002
Q1 2003
Q3 2003
Q1 2004
Q3 2004
Q1 2005
Q3 2005
Q1 2006
Q3 2006
Q1 2007
Q3 2007
Q1 2008
Q3 2008
Q1 2009
Source: Bureau of Economic Analysis
But the damage has been done - 6.6M jobs lost so far
Already double the last recession
9.4% Unemployment
500 10.0%
Monthly net change (000)
Unemployment rate
9.0%
300
8.0%
100 7.0%
6.0%
-100
5.0%
-300
4.0%
-500 3.0%
2.0%
-700
1.0%
-900 0.0%
2001
2002
2003
2004
2005
2006
2007
2008
2009
Monthly employment change Unemployment rate
Source: Bureau of Labor Statistics (Sum of one-month net change for the quarter, Total non-farm, seasonally adjusted)
Job market in bad shape
Current recession job losses vs. notable recessions of past 40 years
1974 1981 1990 2001 2007
1.0%
Percent Cumulative Job Loss Relative to Peak Employment M
0.5%
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
-3.0%
-3.5%
Current Recession
-4.0%
-4.5%
-5.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48
Number of Months After Peak Employment
Source: Jones Lang LaSalle, Moody’s Economy.com, Bureau of Labor Statistics
Only energy, government and healthcare still growing
Education and health services 2.0%
Utilities 1.3%
Government 0.0%
Other services -2.0%
Leisure and hospitality -2.1%
Retail trade -4.1%
Trade, transportation, and utilities -4.7%
Financial activities -5.1%
Wholesale trade -5.1%
Information -5.7%
Professional and business services -6.6%
Mining and logging -6.7%
Transportation and warehousing -7.0%
Manufacturing -12.2%
Construction -14.6%
-20.00% -15.00% -10.00% -5.00% 0.00% 5.00%
Source: Bureau of Labor Statistics 12-month percent change
Percent change total jobs from June 2008-2009
-11.0%
-10.0%
-9.0%
-8.0%
-7.0%
-6.0%
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
Washington, DC -1.4%
Dallas -1.9%
Source: Bureau of Labor Statistics
New York City -2.6%
Houston -2.7%
Boston -2.7%
Raleigh -3.0%
Philadelphia -3.4%
Seattle -3.7%
Minneapolis -3.7%
Miami -4.1%
Denver -4.3%
Jacksonville -4.3%
from a job growth perspective
Fort Lauderdale -4.4%
Chicago -4.5%
Tampa -4.5%
Los Angeles -4.6%
West Palm Beach -4.6%
San Francisco -4.7%
Orlando -5.1%
Atlanta -5.5%
Charlotte -6.2%
Las Vegas -6.5%
Phoenix -7.6%
Energy and government focused markets fairing best
Detroit -9.0%
Property fundamentals
19
Office property clock
Q2 2009 Houston, Washington DC
Atlanta, Boston, Charlotte,
Chicago, Los Angeles, Miami,
New York , Philadelphia, San
Demand Drivers Francisco, Seattle
• 6.5 million job Ft. Lauderdale, San Diego,
losses Silicon Valley
• Heavy financial and Detroit, Las Vegas,
Orange County, Orlando,
service sector job Phoenix
cuts Slowing market Falling market
Cincinnati, Cleveland, Dallas
• Corporate cost
cutting and Fort Worth, Minneapolis,
sublease space Kansas City
Rising market Stagnant market
• Inability of tenants
to make long term
decisions
Source: Jones Lang LaSalle IP
20
Sublease space has increased substantially over the past
several quarters
•SF
140,000,000
120,000,000
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
Peak during last Q2 2007 Q3 2008 Q4 2008 Q1 2009 Q2 2009
downturn '01 - '03
Office market vacancy history and comparison
Boston market is volatile and approaching previous peak
25
US Average Greater Boston
DC
20
15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: JLL and REIS
Greater Boston is a notoriously challenging place to build
Current issue is under-demand rather than over-supply
9,000,000 Forecast
Boston Cambridge Suburbs
8,000,000
7,000,000
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
Greater Boston office statistics
Size Vacancy Net Avg Class Decline
(MSF) % Absorption A Rent from peak
Greater Boston 155.0 19.9% -1.6% $31.22
Boston 58.7 16.6% -2.8% $44.20 24.8%
Cambridge 10.7 16.0% -2.3% $34.85 26.1%
Suburbs 85.6 22.6% -0.7% $22.62 7.9%
• Leasing activity down dramatically and net absorption will remain negative even when activity picks up again
• Significant shadow space exists that will accommodate hiring when growth resumes
• Tenant favorable market conditions will continue leading to further rent declines and increasing concessions
• Some tenants taking advantage of favorable market conditions to upgrade, relocate, and “go long” but most still in
shock and favoring short tern renewals
24
Capital markets trends
25
Capital Markets dislocated
• Real estate lender balance sheets are overburdened with “bad” assets and face dueling
pressures to lend, not lend.
• Widespread distress only beginning to develop, more is inevitable
• Lack of financing and bid-ask gap severely limiting real estate liquidity
• Fear still driving market participants
• Debt and equity capital is available on a limited basis at the right price
• Cash is king
• Government responding but not much help yet – TALF, PPIP, etc
26
U.S. CMBS market lies dormant, return date unknown
CMBS made up 1/3 of originations at the peak and now 21% of outstanding
mortgages
$240
$210
US CMBS Issuance ($ Billions)
$180
$150
$120
$90
$60
$30
$0
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
Source: Jones Lang LaSalle, Commercial Mortgage Alert
27
Investment transaction activity in unprecedented fall
Volume down 80% in H1 2009 from last year
Total transaction volume – office, industrial, retail, multifamily
$450
2009 annual
$400
Total Transaction Volume ($ Billions)
estimate of $40B
$350
only 10% of peak
$300
$250
$200
$150
$100
$50
$0
1
2001
2002
2003
2004
2005
2006
2007
2008
2009 H
* Properties of at Least $5 Million
Source: Jones Lang LaSalle, Real Capital Analytics
28
Equity underwriting and return expectations
What a difference two years make!
A quality US assets Cap rate range
in major markets • Cap rate = NOI / Market value
2Q2007 2Q2009 • NOI down from rent and vacancy
Industrial 4.5-5.5 7.5-9.5
• Cap rates up 200-300 bps
Multifamily 4.0-5.5 6.5-8.5 • Debt assumptions drastically
different – LTV and cost of capital
Office 5.0-6.0 7.0-9.0
• Market values down 30 – 50%
Retail 5.5-7.5 8.0-9.5
• Currently no market data points
29
Near term loan maturities will need to be addressed
$500
Banks Insurance Co's CMBS Total
$419.90
$400 $369.40
$305.70 $320.40
$300
Billions
$200
$100
$0
2009E 2010E 2011E 2012E
CMBS total includes both fixed and floating rate loans to first maturity.
Source: Jones Lang LaSalle, ACLI, Federal Reserve, Wachovia Capital Markets
30
Distressed properties continue to mount, but still
represent just the tip of the iceberg
Cumulative build-up of distressed assets by property type
$120
Apartment Industrial Office
$100
Volume of distressed properties ($ billions)
Retail Hotel All Other
$80
$60
$40
$20
$0
Jul-0 9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
Oct- 0
Jan- 0
Mar -0
Jun- 0
Jan- 0
Mar -0
Jun- 0
Apr- 0
Apr- 0
Aug- 0
No v- 0
De c- 0
May-0
May-0
Feb -0
Sep- 0
Feb -0
Source: Real Capital Analytics, Jones Lang LaSalle
Strategy
implications
32
A Landlord’s Perspective
Then Now
Landlord’s market Tenant’s market
Confident Nervous
Increasing rents, few concessions Decreasing rents, increasing concessions
Capital availability Capital preservation
Extensive capital budgets Minimal capital budgets
Vacancy adds value Tenant retention adds value
No hurry on renewals Blend and extend now
Limited flexibility on lease terms Ultimate flexibility on terms and options
Underwrite tenant’s business Underwrite banks issuing a letter of credit
Landlord checks tenant credit Tenant checks landlord credit
Few phone calls to/from lenders Many phone calls to/from lenders
33
Asset management strategy
• Focus on retaining occupancy and keeping tenants
• Renegotiate with tenants for blend and extend, especially if credit tenant
• Try to avoid tenant bankruptcies and get ahead - ties up space for months
• Like short-term deals with minimal TI, long term leases locking in low rents are bad for exit
value which was a huge part of expected returns in most cases
• Debt maturities are key and looming - for portfolios, could cause issues if there are loan
covenants on even one asset related to portfolio performance - LTV, net worth
• Some landlords looking at opportunity to do work and improve buildings, but most don't have
a lot of capital to spend
• Position building for what little leasing activity there is – close connections with leasing teams
34
Property management strategy
• HUG your tenants – retention is absolutely critical
• Stay close to your best vendors – you will need them
• Back to basics (with a focus on cost cutting) - value will come from running a better building
• Understand that tenants are looking hard at reducing costs so escalation scrutiny and
collection will become more challenging
• Spend extra time reviewing the monthly operating statements to identify negative changes
before they solidify, making recovery more difficult
• Look at your biggest expenses and focus on efficiencies (sustainability and real estate tax
abatement rule the day).
35
Real Estate
Outlook
36
Government to the rescue
• We are in a new era of government intervention and regulation
• Fed Funds target interest rate effectively at 0% and likely to stay there
• $4 trillion in aid, bailouts, and stimulus spent out of $12 trillion committed
• Federal Reserve, Treasury, FDIC, FHA and Congress in all out war against recession
• Special facilities targeting Commercial real estate
• TALF
• PPIP
• Short term government is the lender and spender of last resort
• Longer term US public sector debt could be a huge problem, especially if interest rates
increase
37
What will the recovery look like?
• Growth likely to be slow in a credit constrained
environment and with consumer and financial
deleveraging not nearly complete
• Property fundamentals likely to lag 12 months
behind a turn in the broader economy
(employment)
• Pressure will build on lenders and owners to
close the bid/ask gap and dispose real estate
assets
• Government, technology, health and education
should lead the recovery
• Finance, manufacturing, and retail have
structurally changed and will have long slow
How long will the recovery
• Real estate will generally revert to being a long-
hangover last? term investment vehicle that provides income
What can you do now!
• Don’t miss this learning and career
opportunity
• If possible, understand the capital stack, who
is involved and where does the value "sit"
• Communicate without being a PIA - and think
through options of solutions for problems that
arise
• Get organized and be prepared for the
unexpected
• Step up and take ownership of a project
outside of your job description
This could be your day
in the sun