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					THE LINNEMAN LETTER
           Volume 10, Issue 4                                                                                                                           Winter 2010-11

2007 was initially held by homebuilders, eventually sold
to speculators or financially unqualified homeowners,                                              Net Pent-up Demand as a Percent of Housing Inventory

and ultimately foreclosed upon by mortgage banks.                                           1.5


    Household Formation. We believe that we no lon-                                         1.0

                         ger have too much housing,




                                                                                  Percent
   We believe that but rather too few households.                                           0.5


 we no longer have Over the course of the reces-                                            0.0


 too much housing, sion, the historical marginal                                            -0.5

 but rather too few household size of 2.28 people                                              2004            2005      2006       2007      2008        2009     2010E

                         soared to over 6. If we compare
     households.                                                      figure 134
                         only the incremental population
against new household formations each year, household
formations are significantly lagging historical averages                                               Change in Householder Mobility Rate, 2005-2009
because of a dramatically increased marginal household                                5
                                                                                      0
size. Households that we would have expected to form                                 -5

have not been created because of the lack of jobs. On                              -10




                                                                        Percent
                                                                                   -15
a cumulative basis from 2004 through the end of 2007,                              -20
                                                                                   -25
the historical norm for household formations held true.                            -30

Namely, for every 2.28 people coming into the economy,                             -35
                                                                                   -40
a new household was formed, with each new household                                                Under Age     Age 35-64    Age 65    Under Age    Age 35-64    Age 65
                                                                                                      35                     and Over      35                    and Over
consuming a housing unit.                                                                                                        Renters


                                                                      figure 135


                              U.S. Homeownership Rate
           72                                                         an excess inventory of a 1.8 million housing units (1.2
           70                                                         million rental + 0.6 million single-family homes), versus
           68
                                                                      2.2 million unformed households. Thus, if pent-up
 Percent




           66
           64
                                                                      households were to form, a shortage of 400,000 housing
           62                                                         units would exist. Of course, that will not happen
           60
                                                                      overnight, but it demonstrates the magnitude of pent-up
            1985       1990          1995      2000     2005   2010
                                                                      demand.
                                                                          When and how will households form? Quite simply,
figure 133
                                                                      we believe that as hiring occurs, pent-up households will
                                                                      quickly disperse into both rental and single-family housing,
    From mid-2008 through (estimated) 2010, we                        and in so doing will rapidly absorb excess inventories.
continued to add population but not households. It took               Rental housing will benefit disproportionately, as pent-
not 2.28 people to create a                                           up households are concentrated among the young, who
household over the past two    …it took three times                   have delayed renting an apartment. As jobs are created
years, but rather 6.6 people. the number of people                    over the next three years, 2.2 million pent-up households
Stated differently, it took     over the last three                   will form, with almost 55% (1.2 million) owning and
three times the number of        years to create a                    45% (1.0 million) renting. The rental proportion for the
people over the last three        household as is                     pent-up households is relatively high due to the relatively
years to create a household                                           young age of pent-up households. This is on top of the
as is historically the case.
                              historically the case.                  3.95 million households that will form as the result of
These pent up households represent nearly 2.2 million                 population growth of 9 million over the next three years
“missing” households by year-end.                                     (based upon the historical marginal household size of
    Why are people just staying at home? Quite simply,                2.28 people per household). Of these households, about
absent jobs, households do not form. We currently have                two-thirds (2.6 million households) will be single-family

                                                                                                                                                                            37
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                             Winter 2010-11

                                                                                              Single Family Home Forecast
                                                   2011                       2012                        2013                    2014                  2015
 Supply
   Vacant (relevant)                            1,981,000                    915,189                      149,378                (216,433)             132,146
 + New                                            600,000                    900,000                    1,300,000               1,600,000            1,800,000
 - Destroyed (1)                                 (333,000)                  (333,000)                    (333,000)               (333,000)            (333,000)
 = Total                                        2,248,000                  1,482,189                    1,116,378               1,050,567            1,599,146
 Demand
   Primary (2)                                  1,272,981 (3)              1,272,981    (3)
                                                                                                        1,272,981 (3)            877,193 (4)           877,193
                                                                                                                                                                   (4)

 + Second Homes (5)                                59,830                     59,830                       59,830                 41,228                41,228
 = Total                                        1,332,811                  1,332,811                    1,332,811                918,421               918,421

      End of Period Vacant                        915,189                    149,378                      (216,433)               132,146              680,725
      Excess Vacancy (6)                          (91,401)                  (864,583)                   (1,242,965)              (910,857)            (381,349)
      % Change New Starts                            36%                        50%                           44%                    23%                  13%

      % Change Real Home Price
        First Quarter                                  +                       +++                           +++                    +++                  +++
        Second Quarter                                 +                       +++                           +++                    +++                  +++
        Third Quarter                                 ++                       +++                           +++                    +++                  +++
        Fourth Quarter                               +++                       +++                           +++                    +++                  +++

      Source: Linneman Associates
      (1) Two-thirds of 500,000 total units destroyed annually; 2/3 factor represents the proportion of destroyed units which are SF.
      (2) Two-thirds of household formations are single family; the other third is rental.
      (3) SF household formations are 55% of pent-up demand + two-thirds of normal share from population growth.
      (4) Normal household formation
      (5) Second home demand is 4.7% of primary demand.
      (6) Excess vacant units above the historical (25-year) norm of 1.3%

figure 136



                                                                                                        Multifamily Forecast
                                                          2011                    2012                        2013                2014                  2015
 Supply
   Vacant (relevant)                                   4,578,000                3,788,910                   3,109,821           2,510,731             2,255,468
 + New                                                   140,000                  250,000                     330,000             350,000               350,000
                      (1)
 -    Destroyed                                           (166,667)              (166,667)                   (166,667)            (166,667)            (166,667)

 = Total                                               4,551,333                3,872,244                   3,273,154           2,694,064             2,438,801

 Demand
                (2)                                                  (3)                          (3)                     (3)                 (4)                    (4)
      Primary                                             762,423                 762,423                    762,423              438,596              438,596
 + Second Homes                                                  0                            0                       0                  0                     0

 = Total                                                  762,423                 762,423                    762,423              438,596              438,596

      End of Period Vacant                             3,788,910                3,109,821                   2,510,731           2,255,468             2,000,205
                            (5)
      Excess Vacancy                                      419,913                (266,094)                   (878,740)          (1,149,220)          (1,419,700)
      % Change New Starts                                    40%                     79%                         32%                   6%                   0%

      % Change Real Rents
        First Quarter                                        FLAT                          +                     +++                 +++                  +++
        Second Quarter                                       FLAT                          +                     +++                 +++                  +++
        Third Quarter                                        FLAT                          +                     +++                 +++                  +++
        Fourth Quarter                                          +                         ++                     +++                 +++                  +++

      Source: Linneman Associates
      (1) One-third of 500,000 total units destroyed annually; 1/3 factor represents the proportion of destroyed units which are MF.
      (2) Two-thirds of household formations are single family; the other third is rental.
      (3) MF household formations are 45% of pent-up demand + one-third of normal share from population growth.
      (4) Normal household formation
      (5) Excess vacant units above the historical (25-year) norm of 8.3%

figure 137



38
THE LINNEMAN LETTER
       Volume 10, Issue 4                                                                                                                                                                        Winter 2010-11

                                                                                                                                    family and 650,000 multifamily home starts will occur
                                                  Single Family Construction Put In Place
                                                                                                                                    over the next three years. The net result will be that we
                              800
                              700
                                                                                                                                    burn through the excess inventory. Low single-family
                              600                                                                                                   inventory levels will create strong upward pressure on
   $ Billions




                              500
                              400
                                                                                                                                    home values, restoring some lost confidence in homes as
                              300                                                                                                   an investment. In fact, a crazy but true research result is
                                                                                                                                    that many people use the past year’s home price increase
                              200
                              100
                                      0                                                                                             to estimate future annual appreciation. This means that as
                                      1995              1998          2001            2004          2007            2010
                                                                 Nominal                Real 2008 $                                 home prices stabilize, so too will the belief in long-term
                                                                                                                                    appreciation.
figure 138
                                                                                                                                        Our statistical analysis of household formation since
                                                                                                                                    1948 reveals that household formation is primarily driven
                                                          Single Family Starts Forecast                                             by population growth. In fact, we find that a 1% increase
                                     2,000
                                                                                                                                    in population growth generally leads to a 1% increase in
                Thousands of Units




                                     1,500
                                                                                                                                    households. However, this relationship is very different in
                                     1,000                                                                                          a very weak economy. Specifically, if the unemployment
                                      500
                                                                                                                                    rate exceeds 7%, a 100-bp increase in population only
                                                                                                                                    generates a 30-bp increase in households. That is, in a weak
                                          0
                                                                                                                                    economy, population growth largely fails to translate into
                                          1959   1965     1971
                                                         SF (LTM)
                                                                   1977   1983     1989   1995    2001
                                                                                      Forecast of SF (LTM)
                                                                                                           2007    2013
                                                                                                                                    household growth. As the unemployment rate approaches
                                                         Forecast of SF (SA)                                                        10%, the decline in household formation approaches 75
figure 139                                                                                                                           bps in spite of 1% population growth, meaning that very
                                                                                                                                    few households are formed despite population growth.
                                                                                                                                    We also find that if the unemployment rate is above 7%,
                                                               Multifamily Starts Forecast                                          a 100-bp increase in the unemployment rate wipes out
                                 1,200

                                 1,000
                                                                                                                                    90 bps of household growth. A final result is that as the
         Thousands of Units




                                     800                                                                                            portion of the population under the age of 29 increases,
                                     600                                                                                            household formation increases. Specifically, a 100-bp
                                     400                                                                                            increase in the percent of the population under the age of
                                     200
                                                                                                                                    29 spurs a 30-bp increase in household formation.
                                          0
                                          1959   1965     1971     1977   1983     1989    1995   2001      2007   2013
                                                                                                                                        The flip side of these results is that as the economic
                                                          MF (LTM)                        Forecast of MF (LTM)                      recovery takes hold, the rate of household formation will
                                                          Forecast of mf (SA)
                                                                                                                                    substantially exceed the rate of population growth. Our
figure 140                                                                                                                           analysis suggests that until the unemployment rate falls
                                                                                                                                    below 7%, each 100-bp decrease in the unemployment
buyers and one-third (1.3 million) will rent. Hence, over                                                                           rate will generate a 190-bp growth in households if the
the next three years, we anticipate 3.8 million new single-                                                                         population grows by 1%. That is to say, an explosion of
family households and 2.3 million renter households.                                                                                pent-up households should occur over the next three years
     Statistical Forecast. Meanwhile, based on our                                                                                  as the unemployment rate falls. This release of pent-up
statistical forecasts, we anticipate that 2 million single-                                                                         households will result in the quick absorption of excess

                                                                                                         Summary of Household Formation Variables

                                                                                Annual Obs.          Mean             Std. Dev.       Minimum       25th Percentile   50th Percentile   75th Percentile   Maximum
Household Formation                                                              1948-2009            1.8%              0.8%             0.3%             1.2%              1.8%              2.3%          4.5%
Population Growth                                                                1948-2009            1.2%              0.3%             0.9%             0.9%              1.1%              1.4%          2.0%
Job Growth                                                                       1948-2009            1.8%              2.1%            -4.3%             0.7%              2.1%              3.2%          5.8%
Unemployment Rate                                                                1948-2009            5.7%              1.5%             2.9%             4.6%              5.6%              6.7%          9.7%
Percent of Total Population 20 to 29 years old                                   1948-2009           15.0%              1.9%           12.2%             13.7%             14.5%             16.5%         18.3%
Real GDP Growth                                                                  1948-2009            3.3%              2.5%            -2.6%             2.0%              3.4%              4.6%          8.7%


figure 141



                                                                                                                                                                                                                    39
THE LINNEMAN LETTER
          Volume 10, Issue 4                                                                                                                                    Winter 2010-11

vacancy in both single- and multifamily homes, swinging
the housing market from an economic depressant to a                                                                  Index of Residential Renovations to GDP
source of economic growth.                                                             150
                                                                                                                                                                       1993-2005 Avg
    There is a myth that the overhang of foreclosed                                    130                                                                             Indexed to 100

housing units increases the supply of housing units,                                   110

thereby depressing housing prices. This is wrong, as the                                90

foreclosure of a housing unit simply changes the name                                   70

on the title, not the housing stock. Stated differently,                                50
                                                                                              1993            1995    1997    1999    2001      2003     2005     2007      2009
a foreclosure sale means that a housing unit that was
once owned by a speculator or lender is sold by the
                                                                                      figure 143
foreclosing lender to an entrepreneur, who buys the
unit out of foreclosure to either rent or resell. But the
absolute number of housing units, and hence the supply                                                          Cumulative Excess Renovations based on Index
of housing, is unchanged by the name on the title.                                                                   of Residential Renovations to GDP

    There is a subtle way in which the large foreclosure                                200

inventory impacts housing prices and the economy.                                       150
                                                                                        100
Specifically, as a unit is foreclosed, it switches from being                              50

a unit valued at a retail price to a unit sold at a wholesale                                     0
                                                                                        -50
price. This dilutes housing price information, which is                                -100

generally reflective of retail prices. This makes measured                             -150
                                                                                                  1993        1995    1997     1999    2001     2003     2005      2007     2009
price declines appear larger than actual retail price
declines, as the typical foreclosure buyer is a wholesaler                            figure 144
who subsequently resells at a higher retail. Such tainted
housing price information may confuse consumers who                                   residential renovations relative to GDP ran substantially
think housing price changes reflect retail price changes.                             above the norm from 2003 through the end of 2007. Since
The inclusion of large numbers of wholesale purchases                                 2007 they have run approximately 10% below historical
may thus dampen consumer confidence and perceived                                     norm. However, a cumulative excess still exists. As a
wealth. This may reduce consumption, which in turn                                    result, we anticipate that residential renovations will run
reduces economic growth. However, this more subtle                                    approximately 10% below their norm relative to GDP for
impact of foreclosures is rarely what people have in mind                             another 2-3 years, as this excess is burned off.
when they speak about the foreclosure overhang.
    Housing Renovations. An important component                                                             Peak-to-Trough Change in Real Annual Value Put in Place
of housing expenditures is renovation and remodeling                                                    0
expenditures. These expenditures are far less volatile than                                           -10
                                                                                                      -20
housing starts. However, they have declined substantially
                                                                                        Percent




                                                                                                      -30
over the course of the cycle. Our analysis reveals that                                               -40
                                                                                                      -50
                                                                                                      -60
                                                                                                      -70
                                                                                                      -80
                               Residential Renovations                                                         Mid-1970s        Late 1970s         Late 1980s        Late 2000s to
                                          (Real 2005 $)                                                                                                                    Date
               200                                                                                              Owner Improvements            New Residential Construction

               150                                                                    figure 145
  $ Millions




               100

                50
                                                                                          Our statistical analysis of real renovation and repair
                 0

                 1993   1996   1999        2002       2005     2008     2011   2014
                                                                                      expenditures reveals a strong correlation with real GDP,
                                 Actual                      Expected                 with a $1 billion increase in real GDP increasing real
                                                                                      remodeling expenditures by about $14 million. Also,
figure 142                                                                             a 1,000-unit increase in housing starts increases real

40
THE LINNEMAN LETTER
   Volume 10, Issue 4                                                                                                                             Winter 2010-11

remodeling expenditures by about $32 million, while a
100-bp increase in 30-day Treasury rates increases real                       450
                                                                                               Income Thresholds for Percentile Classes

remodeling expenditures by about $4.6 billion. Other                          400
                                                                              350
things equal, we find that an increase in the unemployment




                                                                $ Thousands
                                                                              300

rate serves to increase remodeling expenditures,
                                                                              250
                                                                              200
suggesting that other things being equal, remodeling                          150
                                                                              100
expenditures and new housing are substitutes. Our                              50
                                                                                0
dominant result is that real remodeling expenditures are                           1980      1983   1986      1989     1992      1995   1998     2001   2004     2007
strongly pro-cyclical, rising with variables that indicate a                              Top 1%           Top 5%          Top 10%         Top 25%           Top 50%

strong economic upswing.
                                                               figure 146

So Who Will Pay?
     Nearly 50% of all American households pay no federal      out at 35%, and will be applied after an exemption of $5
income tax. That is, half of all American households           million per person.
benefit from a federal government, yet pay nothing for              In the Spring 2008 issue, we examined the troubling
its existence. And this percentage has steadily increased      trend of the long-term upward creep of the de facto
during both Republican and Democratic administrations,         zero income tax threshold. The combined effects of the
as both parties understand the political attractiveness of     increasing breadth of the Earned Income Tax Credit
raising the zero tax bracket. It has reduced our nation’s      (EITC) and falling tax rates created a situation in which
sensitivity to wasteful government spending, as only           estimates of 2008 zero tax filers range from 36% (Tax
about half of the citizenry any longer bears the burden        Foundation) to 49% (Tax Policy Center). That is, a
of this waste.                                                 staggering estimated average of 42.5% of tax filers
     On January 1, 2010, the federal estate tax (e.g.,         effectively paid no federal income taxes, while the 1%
“death tax”) became zero, over Democratic protests. But        of taxpayers with the highest income paid about 40% of
this Bush tax cut, like many others, was set to expire on      all income taxes.
January 1, 2011. In December, the Republicans drew a                In 1960, according to the Tax Foundation, there were
line in the sand, refusing to attend to any other major        about 13 million zero-tax filers, accounting for 21% of all
legislative or regulatory issues pushed by the Democrats       federal filers. By 1969, the number of zero-tax filers had
unless all of the Bush tax cuts were extended. President       held steady, but the proportionate share had gone down
Obama conceded and agreed to extend all of the tax cuts        to 16%. Those numbers had jumped to 20.7 million zero-
(not just the taxes affecting those who make less than         tax filers and a 25% share by 1975. As the population
$250,000 per year), in exchange for yet another extension      grew, the percentage of zero-tax filers declined through
of federal unemployment insurance and a cut in payroll         the 1980s, but has been on a steady upward march since
taxes. While the Republicans wanted the tax cuts to be         the mid-1980s, peaking at 36% in 2008. In comparison,
permanent, both the House and Senate approved a 2-year         the Tax Policy Center estimates that 38% of all federal
extension.                                                     tax-filing households in 2007 were zero-tax payers. The
     Despite much of the Democratic leadership in the
House being less than thrilled with the President’s                                       Share of Adjusted Gross Income Earned by Each Group
concessions (particularly around the estate tax), the                         30

bill was passed by a wide margin. On December 17,                             25

2010, President Obama signed the $858 billion bill into                       20
                                                                Percent




law, extending all of the Bush-era tax cuts on income,                        15

capital gains, and dividends through 2012. In addition,                       10

extended unemployment insurance benefits will continue                         5


through 2011. The payroll tax will decline 2 percentage                        0
                                                                                          Top 1%    Top 2-5%         Top 6-10%    Top 11-25%    Top 26-50%   Bottom 50%
points, and capital investments by businesses made                                                           1980      1990      2000    2008

from September 9, 2010 through the end of 2011 can be          figure 147
completely written off. In 2011, the estate tax will max

                                                                                                                                                                        41
THE LINNEMAN LETTER
           Volume 10, Issue 4                                                                                                                                                                       Winter 2010-11


                                              Federal Tax Burdens                                                                           Change in Share of Federal Taxes under Bush Tax
                                           (share of federal income tax paid)
                                                                                                                                0.3
                                                                                                                                                        Cuts by Income Bracket
            70
            60                                                                                                                  0.2
            50                                                                                                                  0.1




                                                                                                                    % Change
 Percent




            40
                                                                                                                                0.0
            30
            20                                                                                                                 -0.1
            10                                                                                                                 -0.2
                 0
                                                                                                                               -0.3
                 1980       1983    1986      1989     1992     1995       1998       2001     2004   2007
                                                                                                                                       Lowest Quintile      Second        Middle Quintile   Fourth Quintile    Top Quintile
                                                Top 1%                   Bottom 95%                                                                         Quintile


figure 148                                                                                                       figure 151


Center further estimates that this jumped to 49% in 2008,                                                       2007, the top 1% paid more of the overall federal income
and will be about 47% in 2009.                                                                                  tax burden (40.4%) than the bottom 95%, which paid
    In 2001, the first year of the Bush tax cuts, the top                                                       39.4%. The scale tipped back slightly in 2008, with the
1% income bracket had a total tax burden representing                                                           top 1% contributing 38% and the bottom 95% paying
33.9% of taxes paid. This increased to 40.4% in 2007,                                                           41.3% of all federal income taxes. The top 1% also saw
but dropped back to 38% in 2008. Meanwhile, the bottom                                                          their tax burden rise relative to federal spending, from
50% reduced their overall tax burden from 4.0% of total                                                         12.8% in 2003 to 17.9% in 2007, then back to 14.2%
taxes in 2001 to a mere 2.7% in 2008.                                                                           in 2008. Thus, contrary to mythology, the Bush tax cuts
    The share of federal taxes paid by the 1% with the                                                          failed to “favor the rich.”
highest income has risen steadily (irrespective of the                                                               According to the most recent available data, the very
party in power): from about 18% in 1980 to 26% in 1990,                                                         richest 1% of earners bears twice the burden they did when
to 33% in 2000, to a peak of 40% in 2007. Amazingly, in                                                         Jimmy Carter was President. Under President Obama’s
                                                                                                                initial proposed policy for 2011, the Bush cuts for middle
                                                                                                                and lower-class Americans would be extended, while
                                   Tax Burdens by Percentile Classes                                            those for the highest tax brackets would expire. That
             50
                                                                                                                plan also would have reinstated the estate tax and several
             40
                                                                                                                deduction phase-outs, which trigger significant tax rate
 Percent




             30
                                                                                                                hikes for America’s highest taxpayers. The question for
             20
                                                                                                                Congress to answer is, “What percent of all income taxes
             10
                                                                                                                should be paid by the highest-income families?” This
                 0
                 1980       1983    1986      1989     1992      1995      1998       2001     2004      2007
                                                                                                                would answer what is their “fair” share.
                              Top 1%                          Top 2-5%                       Top 6-10%               While the ballooning federal budget deficit must be
                              Top 11-25%                      Top 26-50%                     Bottom 50%
                                                                                                                tamed, further tax hikes on the wealthiest citizens will not
figure 149                                                                                                       restore fiscal sanity; they will only dampen the economic


                                                Top 1% Tax Burden                                                                                          Congressional Pork
                                            as % of Federal Spending and GDP                                                   16                                                                                       35
                 25                                                                                                            14                                                                                       30
                                                                                                                               12
                 20                                                                                                                                                                                                     25
                                                                                                                 Thousands




                                                                                                                                                                                                                              $ Billions




                                                                                                                               10
                                                                                                                                                                                                                        20
       Percent




                 15                                                                                                             8
                                                                                                                                                                                                                        15
                                                                                                                                6
                 10
                                                                                                                                4                                                                                       10
                     5                                                                                                          2                                                                                       5
                                                                                                                                0                                                                                       0
                     0
                                                                                                                                    1991   1993    1995    1997    1999     2001    2003     2005    2007     2009
                     1983          1988              1993              1998             2003             2008
                                                 % of Fed $                % of GDP                                                                       Number of Projects                Pork Spending


figure 150                                                                                                       figure 152



42
THE LINNEMAN LETTER
            Volume 10, Issue 4                                                                                                                                                              Winter 2010-11


                                   Tax Breakdown by Filing Status (2008)                                                                                Earned Income Tax Credit
                                                                                                                                         30                                                                60
               80
               70                                                                                                                        25                                                                50
               60




                                                                                                                                                                                                                $ Billions
                                                                                                                                         20                                                                40




                                                                                                                              Millions
     Percent




               50
               40                                                                                                                        15                                                                30
               30
                                                                                                                                         10                                                                20
               20
               10                                                                                                                         5                                                                10
                 0
                                                                                                                                          0                                                                0
                        Married Filing          Married Filing             Head of                Single
                          Jointly                Separately               Household                                                           1998   2000             2002   2004         2006      2008
                         Percent Not Paying           Percent of All Returns          Percent of Taxes Paid                                                 Total EITC $        Number of Returns


figure 153                                                                                                                    figure 155


growth that benefits all citizens. They will not notably                                                                     tax filers effectively paid         The benefits of
increase tax revenues, and certainly will not restrain                                                                       zero (or negative) income
                                                                                                                                                             this country should be
runaway pork spending.                                                                                                       taxes, a 10.6% increase over
     As outlined in our Spring 2008 article, raising tax rates                                                               2007 alone. It is impossible          borne by all,
for the top income brackets generally lead to more effort                                                                    for us to believe that is           and a majority
to legally minimize taxes. Capital gains will be deferred,                                                                   it healthy for democracy            paying nothing
compensation will be put off, and tax-sheltered gifts will                                                                   to have nearly half of all         creates political
increase. All of these reduce the efficiency of capital                                                                      households with no tax
                                                                                                                                                                  class warfare.
allocation while discouraging work, entrepreneurship,                                                                        burden. The benefits of this
and risk-taking. The top 10% of tax payers already pay                                                                       country should be borne by all, and a majority paying
about 70% of all federal income taxes, versus an income                                                                      nothing creates political class warfare.
share of 46%. The top 1% pays 38% of all income taxes
and controls 20% of all income.                                                                                              Union Benefits?
     While the burden of the richest 1% has doubled over                                                                          Current Washington politics reflect the fact that the
the past 40 years, the share of zero-tax payers has nearly                                                                   only place where unions have an ability to grow is in the
tripled from 15% to 45%. By the late 2000s, 45% of all                                                                       government. As a result, the expansion of government is
families pay no federal income tax. Tax credit programs                                                                      synonymous with the expansion of unions. Is it surprising
designed to encourage job creation, particularly the                                                                         that empirical studies show that the federal government
Earned Income Tax Credit (EITC), have steadily                                                                               is less flexible than even large private companies? Is it
increased over the years. From 1998 to 2008, total EITC                                                                      surprising that federal government workers work less
payments grew from $31.6 billion to $49.3 billion, a                                                                         and are paid more than their private sector counterparts?
56% increase. As these payments increased and the Bush                                                                       These are classic symptoms of union inefficiencies, and
tax cuts for the lower income brackets took effect, the                                                                      no sector is more unionized today than government. And
number of zero-tax payers soared. In 2008, 51.6 million                                                                      it is not surprising that an administration that owes a
                                                                                                                             political debt to unions is bent on expanding the federal
                                                                                                                             government to assure more union employees.
                                                Zero-Tax Filers
            60                                                                                                40                  Union density, the unionized share of the working
                                                                                                              35             population, has been gradually declining in the U.S. since
            45                                                                                                30
                                                                                                                             1973, driven by the sharp penetration declines in private
                                                                                                                   Percent




                                                                                                              25
 Millions




            30                                                                                                20             sector unions in the face of increased global competition.
                                                                                                              15             For all wage and salary workers across the public and
            15
                                                                                                                             private sectors, union density was 24% in 1973, 23% by
                                                                                                              10
                                                                                                              5
               0                                                                                              0              1980, 16% in 1990, 13.5% in 2000, and 12% in 2010. The
                 1950       1958         1966       1974         1982       1990        1998       2006
                                                                                                                             percentage of workers covered by collective bargaining
                                     Number of Filers                   Percentage of Filers
                                                                                                                             is generally 1-3 percentage points higher than union
figure 154                                                                                                                    membership, but follows the same trend.


                                                                                                                                                                                                                43
THE LINNEMAN LETTER
                Volume 10, Issue 4                                                                                                                                                                    Winter 2010-11

                                                                                                                               Within the public sector, the composition of union
                                    Union Membership Among All Wage and Salary Workers
                                                                                                                           workers has shifted. For example, the unionization of
                       30
                                                                                                                           federal employees (excluding postal workers) declined
                       25
                                                                                                                           modestly, from 19.4% in 1983 to 18% in 2009. Union
                       20
                                                                                                                           density in the Postal System showed the most dramatic
 Percent




                       15

                       10                                                                                                  decline during this period, dropping from 74.2% to
                        5                                                                                                  63.2%. In contrast, the unionization of state and local
                        0                                                                                                  workers increased by 400 bps and 110 bps, respectively,
                             1973     1977      1981      1986     1990      1994     1998         2002   2006      2010
                                            Union Membership                  Covered By Collective Bargaining
                                                                                                                           between 1983 and 2009.
                                                                                                                               In 1983, federal union workers, including postal
figure 156
                                                                                                                           workers, represented 17.3% of total government union
                                                                                                                           employees; this fell to 12.7% by 2009. State union
                                                Number of Workers in Unions                                                employees have increased from 18.7% to 25.6%, while
                       15                                                                                                  local union employees have fallen from 64% to 61.2%
                       13
                                                                                                                           of government union workers. As a result, the massive
 Millions of Workers




                       11
                        9                                                                                                  federal transfer payments to state and local governments
                        7
                        5                                                                                                  in 2008-2010 represent substantial bailouts for the state
                        3
                                                                                                                           and local union workers, who would otherwise face
                        1
                        -1                                                                                                 cutbacks from lack of funds.
                             1973           1979          1986         1992           1998            2004          2010
                                                      Private Sector        Public Sector

                                                                                                                                                 Union Membership Among Private Sector Workers
figure 157
                                                                                                                                         40
                                                                                                                                         35

    The private and public sectors have experienced                                                                                      30
                                                                                                                            Percent




                                                                                                                                         25
vastly different trends over the last 35 years. In 1973,                                                                                 20

union densities were on par with each other in the private                                                                               15
                                                                                                                                         10
(24%) and public (23%) sectors. However, by 1980,                                                                                         5

private-sector union membership dropped to 20%, while                                                                                     0
                                                                                                                                          1929    1938      1947     1956    1965      1974    1983       1992    2001     2010
public membership jumped to 36%, which is where it
remains in 2010. In contrast, 2010 union membership in                                                                     figure 159
the private sector has fallen to 7% and is still declining.
On an absolute level, the number of unionized public
employees in 1973 was just over 3 million, while                                                                                                          Private Sector Membership In Unions
                                                                                                                                         50
unionized private workers were nearly 15 million strong.
                                                                                                                                         40
Today, each sector has union membership of about 7
                                                                                                                               Percent




million workers.
                                                                                                                                         30

                                                                                                                                         20

                                                                                                                                         10
                                            Public Sector Membership In Unions                                                            0
                       100                                                                                                                       1973              1980             1990           2000             2010

                        80                                                                                                                        Total       Construction      Non-Agricultural          Manufacturing
   Percent




                        60
                                                                                                                           figure 160
                        40

                        20

                         0
                                                                                                                               Private sector union membership peaked in the early
                                     1983              1990               2000              2005             2009          1950s at about 35%, and has since fallen steadily to just
                                             Total
                                             Postal
                                                          Federal (Excludes Postal)
                                                          State
                                                                                              Local
                                                                                                                           7% today. In 1973, the construction and manufacturing
                                                                                                                           sectors both had 39% union density rates, which dropped
figure 158
                                                                                                                           to 13.1% and 11.3%, respectively, by 2010.

44
THE LINNEMAN LETTER
      Volume 10, Issue 4                                                                                                                                                                                       Winter 2010-11

                                                  Government Union Membership                                                                             The Gap Between Full-Time Government Union and
                                                           (Year-over-Year Change)
                                                                                                                                                                 Non-Union Median Weekly Earnings
                15
                                                                                                                                                   300




                                                                                                                               $ Per Week Worked
                10
                                                                                                                                                   200
  Percent




                        5
                                                                                                                                                   100
                        0
                                                                                                                                                     0
                        -5
                                                                                                                                                   -100
         -10
                                                                                                                                                          2000   2001   2002     2003    2004   2005   2006    2007   2008   2009
                             1984          1988           1992             1996            2000       2004           2008
                                           Federal (incl. Postal)                          State               Local                                                           Federal      State      Local


figure 161                                                                                                                   figure 164


     The year-over-year change in government                                                                                     Examining median weekly earnings over the last
unionization reveals shifts among the different levels                                                                      decade, private sector union members have averaged
of government. At the federal level, there was a large                                                                      $141 more per week in earnings then their non-union
decline in 2003, followed by smaller drops until a large                                                                    counterparts. Assuming 48 work weeks per year, this
spike in 2008. However, growth in union employment at                                                                       is equivalent to an annual union pay premium of over
the state and local levels has been generally positive over                                                                 $6,768. In 2009, this union advantage stood at $159 in
the last decade.                                                                                                            earnings per week ($7,632 per year). The comparable
     Not only is there a substantial difference between the                                                                 disparity in weekly earnings in the public sector has
number of union employees in the public versus private                                                                      averaged $145 ($6,960 per year) over the last 10 years,
sector, but unionized public sector workers receive                                                                         rising to $165 by 2009 ($7,920 per year).
significantly higher wages and benefits compared to their                                                                        On a percentage basis, in 2009, unionized private
non-union counterparts. This public-private gap makes                                                                       sector workers earned 23% more than their non-unionized
government ever less cost-effective.                                                                                        counterparts, while the public sector premium was 21%.
                                                                                                                            When comparing private-sector non-unionized workers
                                     The Gap Between Full-Time Union and Non-Union
                                                                                                                            to public-sector unionized workers, the 2009 gap was
                                                Median Weekly Earnings                                                      $250 per week worked ($12,000 per annum), or a 36%
                         200                                                                                                premium.
    $ Per Week Worked




                         150                                                                                                     Surprisingly, within the public sector, unionized
                         100                                                                                                federal employees have consistently earned less than
                             50                                                                                             their non-unionized counterparts by an average shortage
                              0
                                                                                                                            of $28 per week over the last 10 years, and by $38 in
                                    2000    2001    2002     2003          2004   2005      2006   2007      2008    2009   2009. This gap peaked at $69 per week more for non-
                                                                 Private          Public
                                                                                                                            unionized federal employees in 2007. However, research
figure 162                                                                                                                   indicates that this reflects the unionization of lower-
                                                                                                                            skilled jobs, with regression analysis indicating 20-25%
                                                                                                                            wage premiums in federal government employment
                                    The Gap Between Full-Time Union and Non-Union                                           for comparably skilled workers. At the state and local
                                               Median Weekly Earnings
                                                                                                                            government levels, unionized employees earned an
                         40
                         35                                                                                                 average of $116 and $206 more per week, respectively,
                         30
                         25                                                                                                 than their non-unionized colleagues over the last 10
       Percent




                         20
                         15
                         10
                                                                                                                            years, despite notably lower skill levels. In 2009,
                          5
                          0
                                                                                                                            unionized state and local government employees earned
                                  2000     2001    2002     2003       2004       2005      2006   2007   2008       2009   $139 and $206 more per week than those who are not
                                     Private Union Premium
                                     Govt Union Premium over Private Non-Union
                                                                                              Public Union Premium
                                                                                                                            union members.
                                                                                                                                 Total compensation costs for union employees are
figure 163                                                                                                                   substantially higher than for non-union employees.


                                                                                                                                                                                                                                    45
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                                                                      Winter 2010-11

                                                                                                               Since 2004, union employees have cost their employers
                                              Employers’ Total Compensation Cost for Employees                 on average $10.39 per hour more than non-union
                                40.00
                                                                                                               employees. The cost gap between unionized and non-
                                                                                                               unionized employees peaked in the fourth quarter of
            $ per hour worked




                                30.00

                                20.00
                                                                                                               2006 at an incremental $11.08 per hour worked, and
                                10.00
                                                                                                               stood at $10.49 per hour worked in mid-2010. With 1
                                  0.00
                                                                                                               million unionized government workers, that translates
                                         2004       2005    2006           2007        2008    2009    2010    into $10 million wasted every hour worked in the federal
                                                                  Union           Non-Union
                                                                                                               government alone! If we assume that there are 48 work
                                                                                                               weeks per year and 37.5 hours per work week, then
figure 165
                                                                                                               that translates into over $18 billion (real 2008 $), or
                                                                                                               about 0.13% of GDP wasted in 2009. If we include all
                                                                                                               7.7 million unionized government workers, that figure
                                                                                                               increases to 1% of GDP. And this ignores the fact that
                                11.50
                                        The Gap Between Union and Non-Union Employer Costs
                                                                                                               these are lower-skilled workers than their private-sector
                                                                                                               counterparts. Thus, over the past seven years, the cost
      $ per hour worked




                                11.00
                            10.50                                                                              premium for federal union workers was $137 billion and
                            10.00
                                 9.50
                                                                                                               $1 trillion for all government unionized workers, even
                                 9.00                                                                          ignoring the financing costs of carrying this deficit.
                                 8.50

                                        2004        2005    2006           2007         2008    2009    2010

                                                                                                                                                    Employers’ Total Benefits Cost for Employees
                                                                                                                                     15.00
figure 166
                                                                                                                 $ per hour worked




                                                                                                                                     10.00


                                                                                                                                      5.00
                                                  Wasted Annual Taxpayer Dollars From
                                                       Unionized Federal Workers                                                      0.00
                                                                   (Real 2008 $)                                                             2004       2005     2006     2007        2008      2009   2010
                                 21
                                                                                                                                                                Union     Non-Union
                                 20
               $ Billions




                                 19
                                                                                                               figure 169
                                 18

                                 17

                                 16
                                       2004       2005     2006           2007        2008     2009    2010
                                                                                                                   Although the growth rates of total employer benefit
                                                                                                               costs for union and non-union workers have been
figure 167                                                                                                      roughly equal (both about 23%) over the past six years,
                                                                                                               the absolute costs for union workers are almost double
                                                                                                               those for non-union workers. In 2004, the total benefit
                                                                                                               cost for a non-union worker was about $6 per hour
                                          Wasted Taxpayer Dollars From Unionized Federal
                                                   Workers as a Percent of GDP
                                                                                                               worked, compared to almost $12 for a union worker. By
                                0.15
                                                                                                               the first quarter of 2010, the costs were $7.46 and $14.26
                                                                                                               per hour, respectively. In the private sector, the total cost
                                0.14
                                                                                                               of employer benefits per unionized worker-hour grew
     Percent




                                                                                                               3.2%, from $13.82 per hour in early 2008 to $14.26 per
                                0.13

                                0.12
                                                                                                               hour in 2010. In comparison, employer benefit costs per
                                0.11                                                                           non-unionized private worker grew 4.3%, from $7.16 per
                                       2004        2005    2006            2007        2008     2009    2010   hour worked to $7.46 during the same period.
                                                                                                                   Non-union laborers have increased their defined
figure 168
                                                                                                               benefits by nearly 14% since 2004, compared to 8.4%

46
THE LINNEMAN LETTER
       Volume 10, Issue 4                                                                                                                                                                    Winter 2010-11

                                                                                                                          The real and open-ended difference is the number of
                                              Employers’ Defined Benefit Cost for Employees                           workers participating in pension benefit packages, with
                                2.00                                                                                  union laborers enjoying the lion’s share. Historically,
                                                                                                                      there are nearly five times as many union workers
       $ per hour worked




                                1.50

                                1.00                                                                                  participating in defined benefit pensions as non-union
                                0.50
                                                                                                                      workers.
                                0.00
                                       2004       2005        2006           2007           2008      2009     2010
                                                                                                                                             Percent of Workers Participating in All Retirement Plans
                                                                 Union          Non-Union

                                                                                                                             100

figure 170                                                                                                                           75




                                                                                                                       Percent
                                                                                                                                    50

for unions. But a union worker’s defined benefit cost is                                                                            25

nearly seven times larger than that of a non-union worker.                                                                          0
                                                                                                                                              1999           2000        2003     2004       2005     2006
In the first quarter of 2010, a union worker’s defined                                                                                                                Non-Union     Union
benefit cost was $1.81 per hour worked, compared to just
$0.25 per hour for a non-union worker.                                                                                figure 173



                                        Employers’ Defined Contribution Cost for Employees                                                   Percent of Workers Participating in Medical Care Benefits
                                0.80
                                                                                                                               100
        $ per hour worked




                                0.60
                                                                                                                                    75
                                                                                                                       Percent




                                0.40                                                                                                50

                                0.20                                                                                                25

                                0.00                                                                                                 0
                                       2004       2005        2006          2007            2008      2009    2010                             1999          2000         2003     2004      2005      2006
                                                             Union          Non-Union                                                                               Non-Union     Union



figure 171                                                                                                             figure 174



    The cost of defined contribution for the typical                                                                      Historically, 36% more union workers participate
employee has increased by 50% since 2004, while this                                                                  in retirement plans than non-union workers, while 30%
cost for non-union workers has “only” increased by 26%.                                                               more union workers will have medical benefits than non-
There is a smaller margin here, though; only 21 cents per                                                             union employees.
hour separate the union employers from the non-union                                                                      In addition, union workers with medical care benefits
employers.                                                                                                            have smaller out-of-pocket contributions for family and


                                                                                                                                              Average Employee Contribution for Family Coverage
                                         Percent of Workers Participating in Defined
                                                                                                                                               Medical Care Benefits (average monthly premium)
                                                      Benefit Pension
                80                                                                                                                   400

                60                                                                                                                   300
                                                                                                                        $ Monthly
 Percent




                40                                                                                                                   200

                20
                                                                                                                                     100

                            0
                                                                                                                                         0
                                         1999        2000            2003            2004          2005      2006
                                                                                                                                                      1999              2004          2005          2006
                                                            Non-Union              Union
                                                                                                                                                                    Non-Union     Union


figure 172                                                                                                             figure 175



                                                                                                                                                                                                              47
THE LINNEMAN LETTER
       Volume 10, Issue 4                                                                                                                           Winter 2010-11


                  Percent of Workers with Medical Care Coverage
                   Required to Contribute toward Cost of Family                                          Social Security Surpluses/Deficits as Percent of GDP

           100                                                                             1.5
                                                                                           1.0
           75                                                                              0.5




                                                                                 Percent
 Percent




                                                                                           0.0
           50
                                                                                           -0.5
           25                                                                              -1.0
                                                                                           -1.5
             0                                                                             -2.0
                      1999             2004           2005           2006
                                                                                                  1970         1990      2010      2030          2050          2070
                                     Non-Union    Union


figure 176                                                                      figure 178


single coverage. On average, non-union employees have
                                                                                                            U.S. Workers per Soc. Security Beneficiary
an average monthly premium that is $80 higher than
union employees. Also, a higher percentage of non-union                                              16.5

employees are required to contribute towards the cost                                      15




                                                                                 Workers
of family coverage than union employees, while more                                        10

union employees have access to benefits for which they                                      5                    3.7     3.4      2.9      2.2          2.1            2
have to pay less.
                                                                                            0
                                                                                                     1950       1970     1990     2010    2030          2050          2070

                 Percent of Workers Participating in Dental Care Benefits
                                                                               figure 179
           80

           60
                                                                               or a meter reader. And the expansion of unions and the
 Percent




           40
                                                                               expansion of government are now synonymous.
           20
                                                                                    One element of the extraordinary level of retirement
            0                                                                  benefits received by many public retirees is captured by
                   1999       2000        2003     2004      2005       2006

                                     Non-Union     Union
                                                                               the fact that in the U.S., public school teachers commonly
                                                                               receive nearly $50,000 a year in retirement payments.
figure 177                                                                      This equates to roughly a $1 million annuity contract per
                                                                               teacher. Stated differently, when you see a typical public
     An example of a benefit that has remained stable                          school teacher nearing retirement age, you are looking at
over the years for non-union workers, but has increased                        a millionaire. When seen in this light, school teachers are
for union workers, is dental care. In 1999, 52% of union                       not so poorly paid!
employees participated in dental care benefits. This had                            We face a critical question today: “Does the private
risen to 63% by 2006.                                                          sector exist to support a unionized government sector, or
     The overall composition of union employees in the                         does the government exist to service the private sector?”
U.S. has dramatically shifted from the private sector to                       Unfortunately the Obama/Pelosi government has so far
the public sector. As the government hires more union                          favored policies that hold that the private sector exists to
employees, global competition and innovation in the private                    feed unionized government workers. This is a reversal of
sector continues to scale back union presence. Yet unions                      the belief that existed in the U.S. from Reagan through
prosper in the government sector, including public school                      Clinton. Under Bush, and even more so under Obama/
teachers’ unions, where they are immune from competitive                       Pelosi, the U.S. has come to resemble Western Europe
market forces. This insidious aspect of the drift towards                      and Japan, where the private sector feeds a politically
ever larger government weighs down the private sector, as                      powerful unionized government sector. If this is the
it must support an ever more expensive government sector.                      route we are on, we too will experience the muted long-
In the “old days,” the face of a union employee was a steel                    term growth rates they have experienced over the past
or auto assembly line worker; today it is a school teacher                     30 years.

48
THE LINNEMAN LETTER
              Volume 10, Issue 4                                                                                                                                                                              Winter 2010-11

What is Privately Owned Commercial Real Estate?                                                                                                  private real estate transactions occur out of the limelight
    One of the most impressive developments of capital                                                                                           of most investors and have very limited transparency.
markets over the past 18 years has been the dramatic
evolution of publicly traded REITS. These publicly traded
                                                                                                                                                                                  NCREIF Index
real estate companies have evolved from a dusty corner                                                                                            2,500
of the capital markets to mainstream, large, publicly                                                                                             2,000
traded firms. This is an evolution we predicted about 13                                                                                          1,500
years ago in a paper entitled “The Forces Changing Real                                                                                           1,000
Estate Forever.” At that time we wrote that this would be
                                                                                                                                                    500
a 25-year process, which we are now roughly halfway
                                                                                                                                                      0
through. These publicly traded firms feature pricing that                                                                                             1978    1982      1986       1990     1994    1998      2002   2006      2010

leads private markets by 12-18 months. As a result, while                                                                                                    Total Return Index           Income Return Index         Price Index


the bottom in REIT valuations occurred in March 2009,                                                                                            figure 182
as we predicted, the valuations of privately traded real
estate have only bottomed over the past six months.                                                                                                   Like pink sheet companies, private real estate
                                                                                                                                                 transactions are highly sensitive to the general flow of
                                          U.S. REIT Equity Offering Proceeds                                                                     funds. Not surprisingly, the major flows of funds are
                                                     (Seasonally Adjusted Annual Rates)
                                                                                                                                                 generally focused on large and mid-size publicly traded
                  60
                                                                                                                                                 companies. However, over the course of every capital
                  50
                  40
                                                                                                                                                 cycle, the flow of funds eventually reaches pink sheet
 $ Billions




                  30                                                                                                                             companies. When this occurs, it is a great opportunity
                  20
                                                                                                                                                 to cash in on the underlying fundamentals of such
                  10
                   0
                                                                                                                                                 companies. This is the case too for privately traded real
                       1984               1989                    1994             1999                      2004                    2009        estate. The essence of both markets is to live on the cash
                                                                                                                Source: Federal Reserve
                                                                                                                                                 flow fundamentals until a capital cycle brings flows
figure 180                                                                                                                                        which allow an attractive exit. Of course, eventually
                                                                                                                                                 these capital flows reverse, leaving the market once more
                                          Net Inflows to Real Estate Mutual Funds
                                                                                                                                                 short of capital and solely reliant on cash flows.
                                                                                                                                                      This pricing volatility relative to the underlying
                                                                                               6.83
                   8
                   6                                 4.06                               4.62
                                                                                                             6.10
                                                                                                                            5.26
                                                                                                                                          4.70
                                                                                                                                                 movement of cash flows for private real estate reflects
                   4
                                0.60
                                              2.55
                                                                                 3.41                 3.16
                                                                                                                                   1.15
                                                                                                                                                 the dramatic impact of flow of funds on these thinly
     $ Billions




                   2     0.39          0.46
                   0
                                                                     0.23 0.03
                                                                                                                                                 traded assets. It means that the mantra for private real
                  -2                                        -0.98
                                                                 -1.32
                                                                                                                                                 estate ownership must be: “Stay alive on cash flow
                  -4
                  -6                                                                                                                             fundamentals, and refinance or sell on flow of funds.”
                                                                                                                    -5.75
                  -8
                        1993       1995          1997           1999     2001       2003          2005          2007           2009
                                                                                                                                                 But this means that debt levels must be kept sufficiently
                                                                                                                    Source: AMG, BAS-ML          low to survive the fundamentals cycle until the capital
figure 181
                                                                                                                                                 cycle is favorable.
                                                                                                                                                      The fact is that banks are the dominant capital
     For the most part, privately owned real estate                                                                                              source, because these investment managers attract funds
represents the ownership of very small companies. For                                                                                            not based on their investment performance, but rather
example, a $20 million strip center or a $40 million                                                                                             on their federally insured depository status. Banks are
garden apartment complex are decently sized private                                                                                              lenders only because regulatory oversight generally
real estate; but in the context of corporations these are                                                                                        forces them to make loans rather than equity investments.
very small companies. In this regard, private real estate                                                                                        If these depositories were required by law to make equity
reminds us of the small companies that trade on the “pink                                                                                        investments rather than debt investments, they would
sheet” stock markets. These pink sheet companies attract                                                                                         gladly do so, as their main business is to attract short
little in the way of analysts, and are largely removed                                                                                           duration capital via federally insured deposits, while
from detailed analysis by most investors. Similarly, most                                                                                        investing in longer-duration assets. Stated differently,

                                                                                                                                                                                                                                  49
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                                                                                                                        Winter 2010-11

these institutions will do whatever their regulators tell                                                                                  10.7% and 8.6%, respectively, both represent the second
them to do in terms of contractual investment, as their                                                                                    consecutive quarter of declines.
fundamental business model makes money off of the                                                                                              Real estate transactions have picked up from their
leveraged spread from mismatched duration investing.                                                                                       bottom. According to Real Capital Analytics, year-to-
     The result is that banks receive huge flows of funds                                                                                  date sales activity through October 2010 increased for all
even though they have shown themselves to be poor                                                                                          major commercial sectors (office, industrial, multifamily,
money managers. At the end of the day, all that matters
is their insured depository status. Unfortunately this
                                                                                                                                                                                   Real Estate Loan Charge-off Rates
means that the dominant flow of funds will invariably                                                                                                     3.5

be debt, as banks are generally required to invest in debt
                                                                                                                                                          3.0
                                                                                                                                                          2.5
if they desire depository insurance. As long as banks




                                                                                                                                                Percent
                                                                                                                                                          2.0

attract capital due to a federal guaranty of deposits, rather                                                                                             1.5

than their investment track records, there will be a skew                                                                                                 1.0
                                                                                                                                                          0.5
toward debt as a contractual form. That is, federal deposit                                                                                               0.0

insurance artificially attracts capital to banks that must                                                                                                     1985          1989            1993         1997          2001
                                                                                                                                                                                      All Real Estate Loans for All Banks (SA)
                                                                                                                                                                                                                                    2005                    2009

be placed as debt. If bank deposits were not insured, far                                                                                                                             All Real Estate Loans for 100 largest Banks (SA)

less capital would be contracted as debt.
                                                                                                                                           figure 183
                                     Is it any wonder that
 Is it any wonder that
                                 when the flow of funds
    when the flow of             cycle is at its peak, over-                                                                                                                             Real Estate Loan Delinquencies
  funds cycle is at its          leverage is the dominant                                                                                                 14
                                                                                                                                                          12
  peak, over-leverage            symptom? It merely re-                                                                                                   10

                                 veals that these federally
                                                                                                                                               Percent




     is the dominant                                                                                                                                      8

                                 insured money managers                                                                                                   6
         symptom?                                                                                                                                         4
                                 have more capital than                                                                                                   2
they can wisely invest, and jam it into nooks and cran-                                                                                                   0

nies at leverage levels far above the norm. Nothing in the                                                                                                    1991                1995                 1999
                                                                                                                                                                                                 Residential
                                                                                                                                                                                                                                 2003
                                                                                                                                                                                                                                   Commercial
                                                                                                                                                                                                                                                  2007


discussion of financial reforms remotely addresses this
underlying problem, which will replay itself as long as                                                                                    figure 184
we continue to have federally insured depositories.
                                                                                                                                                                            Residential Mortgage Delinquency Rates
Real Estate Capital Markets Are Simmering                                                                                                                35
     Real estate loan charge-off and delinquency rates                                                                                                   30

continued to fall in the third quarter of 2010. Charge-
                                                                                                                                                         25
                                                                                                                                            Percent




                                                                                                                                                         20
off rates for all real estate loans by all banks, and at the                                                                                             15
                                                                                                                                                         10
largest 100 banks, peaked in the fourth quarter of 2009 at                                                                                                5

2.76% and 2.99%, respectively, but stood at 2.14% and                                                                                                     0
                                                                                                                                                                2004        2005               2006             2007         2008          2009          2010
2.24% in the latest quarter. Residential and commercial                                                                                                                          All Loans                      Prime                           FHA

delinquencies both peaked in the second quarter of 2010                                                                                                                          Sub-Prime                      Sub-Prime Arm

at 11.4% and 8.8%, respectively. Third-quarter levels of                                                                                   figure 185


                                                                                                    U.S. Sales Transaction Activity - YTD Thru October
                                                     Office                                         Industrial                                 Multifamily                                             Retail                                      Hotel
                                       2009            2010          Change            2009            2010             Change    2009            2010                 Change           2009            2010            Change        2009         2010      Change
 # Properties Sold                      471            787             67.1%            610             785              28.7%       799             1,039               30.0%           775             841              8.5%           134          927     591.8%
 Total Price ($ billions)            $12.3           $24.3             97.5%           $6.6           $11.0              67.0%     $11.2             $21.8               94.0%          $8.6          $13.9             62.2%           $2.2        $11.0     411.0%
 Total Units*                          66.0          129.3             95.8%            109             190              73.5%   140,836         213,191                 51.4%            56              90            60.2%         22,340      124,542     457.5%
 Avg PSF/PPU                          $197            $192             -2.2%            $65             $64              -1.7%   $84,850        $112,613                 32.7%         $149            $148              -1.0%      $104,209     $156,277      50.0%
 Avg Cap Rate                        8.1%            7.8%            -33 bps          8.6%            8.4%             -18 bps     7.0%              6.7%              -26 bps         7.8%           7.9%              12 bps          9.5%         6.7%   -279 bps

 Source: Real Capital Analytics, Linneman Associates
 Units = millions of square feet for office, industrial, r& etail; apartment units for multifamily; rooms for hotel.


figure 186


50
THE LINNEMAN LETTER
                Volume 10, Issue 4                                                                                                                                                                            Winter 2010-11

retail, and hotel), compared to the same period in 2009,
                                                                                                                                               REIT AFFO Yields over 10-Yr. Treasury Yield
with the number of hotel transactions increasing nearly                                                                   1000
sixfold and office activity increasing by two-thirds. On a                                                                 800
dollar-volume basis, total transaction activity increased                                                                  600




                                                                                                           Basis Points
more than fourfold in the hotel sector, nearly doubled                                                                     400
for the office and multifamily sectors, and increased by                                                                   200

about two-thirds in the industrial and retail sectors.                                                                          0

    However, average unit prices dropped for the                                                                          -200

office, industrial, and retail sectors over the same                                                                             1994       1996        1998       2000
                                                                                                                                                               Spread
                                                                                                                                                                                2002          2004       2006
                                                                                                                                                                                               Average Spread
                                                                                                                                                                                                                      2008           2010


comparative periods, while multifamily and hotel unit
                                                                                                          figure 190
pricing increased by 33% and 50%, respectively. Office,
industrial, multifamily, and hotel cap rates declined by
33 bps, 18 bps, 26 bps, and 279 bps, respectively, while
retail cap rates increased by 12 bps year-over-year                                                                       12
                                                                                                                                                       Implied REIT FFO Cap Rates

through October.                                                                                                          11
                                                                                                                          10
    As we predicted in April 2009, the bottoming of                                                                        9




                                                                                                                Percent
private pricing (peaking of cap rates) occurred about                                                                      8
                                                                                                                           7
                                                                                                                           6
                                                                                                                           5
                                                                                                                           4
                                                                                                                           3
                                     Real Estate (Under) Over Pricing Using:
                                               CAPM       BBB Yld Benchmark                                                 2002        2003    2004    2005      2006      2007       2008     2009     2009        2010     2010
                  50                                                                                                                    Total REITs                      Multifamily                    Office          Source: BAS-ML
                    0                                                                                                                   Shopping Centers                 Regional Malls                 Industrial
                 -50
                                                                                                          figure 191
  Percent




                -100
                -150
                -200
                -250
                -300
                       1994   1996      1998    2000   2002    2004      2006       2008        2010                       12
                                                                                                                                                 Implied REIT Cash Flow Cap Rates
                                                                  Liquidity premium assumed to be zero.                    11
                                                                                                                           10
                                                                                                                            9
figure 187
                                                                                                                 Percent




                                                                                                                            8
                                                                                                                            7
                                                                                                                            6
                                                                                                                            5
                          Real Estate (Under) Pricing as of December 17, 2010
                                                                                                                            4
                                              Long-Term Annual Dividend Growth
                                                                                                                            3
                                        1.5%           2.0%          2.5%                    3.0%
                                                                                                                            2002        2003    2004    2005      2006      2007       2008     2009     2009       2010     2010
                           0.3         -20.1%         -42.4%        -74.9%                 -126.5%
                                                                                                                                        Total REITs                  Multifamily                       Office          Source: BAS-ML,
                           0.4           -7.0%        -24.4%        -48.4%                   -84.0%                                                                                                                    Linneman Assoc.
                  BETA




                                                                                                                                        Shopping Centers             Regional Malls                    Industrial
                           0.5            3.5%        -10.4%        -28.9%                   -54.9%
                           0.6          12.2%           0.8%        -13.9%                   -33.8%
                                                                                                          figure 192
figure 188



                                                                                                                                               NOI Cap Rate Spreads over 10-Yr Treasury
                                REIT Div Yld Spread over U.S. Corp Baa Yld                                                                                               (18-month lag)
                300
                                                                                                                      600
                200
                                                                                                                      400
                                                                                                           Basis Points




                100                                                                                                   200
 Basis Points




                   0                                                                                                     0
                                                                                                                     -200
                -100
                                                                                                                     -400
                -200                                                                                                 -600
                -300                                                                                                 -800
                                                                                                                   -1,000
                -400
                                                                                                                                 1980          1984        1988           1992           1996           2000           2004           2008
                       1994   1996      1998    2000   2002    2004      2006       2008       2010
                                                                                                                                            Apartment                    Industrial                  Office                 Retail


figure 189                                                                                                 figure 193



                                                                                                                                                                                                                                            51
THE LINNEMAN LETTER
               Volume 10, Issue 4                                                                                                                                                                                                  Winter 2010-11


                                                                                                                                                                      Return Components of Wilshire REIT Index
                                                       NCREIF Cap Rates                                                                                                                         (thru May 2010)
                                                          (18-month lag)
                                                                                                                                                         35




                                                                                                                                   Cumulative Percent
               20                                                                                                                                        30
                                                                                                                                                         25
               15                                                                                                                                        20
                                                                                                                                                         15
 Percent




               10                                                                                                                                        10
                                                                                                                                                           5
                5                                                                                                                                          0
                                                                                                                                                          -5
                                                                                                                                                        -10
                0
                                                                                                                                                                      1-Year            3-Year             5-Year          10-Year             YTD
                1980           1984             1988           1992           1996          2000         2004           2008
                                                                                                                                                                                                                                             November
                           Apartment              Industrial                Office           Retail           10-yr Treasury
                                                                                                                                                                                  Dividend Return                   Price Return               2010


figure 194                                                                                                                      figure 197


15 months after REIT pricing bottomed in March 2009.
This lag between public and private real estate pricing                                                                                                                          NAREIT Equity REIT Annual Returns
is consistent with the historic patterns of a 12-18-month                                                                                               40
lag in private pricing. Since peaking in the fourth quarter                                                                                             20
of 2009, total REIT implied cap rates have fallen by
                                                                                                                                 Percent
                                                                                                                                                          0
approximately 240 bps, from 9.2% to 6.8%, representing                                                                                                  -20
an FFO multiple increase from 10.9x to 14.7x through                                                                                                    -40
mid-December 2010. In fact, our analysis suggests that                                                                                                  -60
as of December 17, 2010, REITs are approximately 20%                                                                                                           1980       1984         1988         1992      1996        2000       2004          2008
                                                                                                                                                                                                 Income       Price
over-valued relative to BBB bonds, and 5% over-valued
based on the Capital Asset Pricing Model.                                                                                      figure 198
     As pricing has improved, more owners (including
financial owners of foreclosed assets) believe that prices

                               Public and Private Market Real Estate Values                                                                                              Total vs. Price Return of NAREIT Equity Index
                                                               (2001 = 100)                                                                             50

          350                                                                                                                                           40
          300
                                                                                                                                Percent




                                                                                                                                                        30
          250
          200                                                                                                                                           20
          150
                                                                                                                                                        10
          100
               50                                                                                                                                        0
                0                                                                                                                                        1980           1984          1988        1992       1996       2000         2004          2008
                    2001     2002      2003      2004     2005        2006       2007       2008      2009     2010                                                                           Total                    Price
                                        MSCI U.S. REIT Index (Public)
                                        Moody’s/REAL Commercial Property Price Index (Private)
                                                                                                                               figure 199
figure 195



                                Private Real Estate Values by Property Type                                                                                                            REIT Bond Issuance
                                                           (2001 = 100)
               240
               220                                                                                                                                      5.0
               200
               180                                                                                                                                      4.0
 Index Value




               160
                                                                                                                                 $ Billions




               140                                                                                                                                      3.0
               120
               100                                                                                                                                      2.0
                80
                60
                                                                                                                                                        1.0
                40
                     2001      2002     2003       2004        2005     2006         2007     2008     2009      2010                                   0.0
                                    Apartment                  Industrial               Office               Retail                                            1999            2001           2003          2005           2007             2009


figure 196                                                                                                                      figure 200



52
THE LINNEMAN LETTER
                  Volume 10, Issue 4                                                                                                                                                                                         Winter 2010-11

have peaked, as they believe that future growth will be
substantially below what is being priced into the market.                                                                                                            U.S. CDO Annual Market Volume

Only time will tell who is right, but as bullish bidders have                                                                                 600


appeared, it is not surprising that sales have recovered.                                                                                     500




                                                                                                                             $ Billions
                                                                                                                                              400
    The improved outlook for new CMBS issuance and                                                                                            300
the recent improvement in mortgage lending means that                                                                                         200

the upcoming refinance wave will largely resolve itself,                                                                                      100

much as we suggested two years ago. Specifically, huge                                                                                             0
                                                                                                                                                       1996        1998           2000         2002          2004          2006          2008          2010
chunks of land, unfinished developments, and broken                                                                                                                                                                                            Source: SIFMA

condos will simply be written off and sold for $0.05-
                                                                                                                          figure 204
$0.25 on the dollar. On the other hand, cash flow assets


                                             CMBS Spreads (Monthly)                                                                                                       U.S. CDO Monthly Market Volume
                  12,000
                                                                                                                                          200
                                                                                                                                                                                   169.9 178.6
                  10,000
                                                                                                                                                                                                                      2009 Total : $4.3 Billion
   Spread (bps)




                     8,000                                                                                                                150                             120.0                                       2010 YTD: $6.4 Billion




                                                                                                                             $ Billions
                     6,000                                                                                                                                        91.8                           92.7
                                                                                                                                          100
                     4,000                                                                                                                                 60.5
                                                                                                                                                                                                      43.7
                     2,000                                                                                                                    50                                                          19.9      14.3
                           0                                                                                                                                                                                                 0.8        0.6     2.4       2.0
                             1996     1998     2000         2002       2004         2006         2008         2010                             0
                                                                                                                                                   1Q05           4Q05        3Q06        2Q07           1Q08         4Q08          3Q09             2Q10
                                      AAA            BBB               BBB-                BB                B
                                                                                                                                                                                                                                               Source: SIFMA



figure 201                                                                                                                 figure 205




                                             AAA CMBS Spreads (Monthly)                                                                                             Annual Historical U.S. CMBS Issuance
                  1,200
                                                                                                                                          250                                                                                           230
                                                                                                                                                                                                                                  203
                  1,000
                                                                                                                                          200                                                                               169
 Spread (bps)




                                                                                                                          $ Billions




                     800
                                                                                                                                          150
                     600                                                                                                                                                                                               93
                                                                                                                                          100                                             74                78
                                                                                                                                                                                                57 47 67 52
                     400                                                                                                                      50                          26 37
                                                                                                                                                       3    8 14 17 18 16                                                                     12 3    9
                     200                                                                                                                       0
                                                                                                                                                    1990             1994                1998                2002              2006              2010YTD
                       0
                                                                                                                                                                                                                       Source: Commercial Mortgage Alert
                          1996       1998     2000         2002       2004         2006         2008         2010


figure 202                                                                                                                 figure 206




                                              CMBS Delinquencies                                                                                              Monthly Historical Worldwide CMBS Issuance
                10
                                                                                                                                              70
                  8                                                                                                                           60
                                                                                                                                              50
   Percent




                  6
                                                                                                                                 $ Billions




                                                                                                                                              40
                  4                                                                                                                           30
                  2                                                                                                                           20
                                                                                                                                              10
                  0
                                                                                                                                               0
                      1997          2001      2005         2006         2007           2008          2009
                                                                                                                                               1999                2001            2003               2005            2007               2009
                                                              Source: MBA; 1997-2005 annual data; quarterly thereafter.                                                                                               Source: Commercial Mortgage Alert



figure 203                                                                                                                 figure 207



                                                                                                                                                                                                                                                            53
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                                                              Winter 2010-11

with good interest coverage will be able to roll over                             low well into 2013, due to the time it will take to generate
maturing debt with a high degree of success, particularly                         the jobs necessary to refill the empty space, and an
with both long- and short-term interest rates at historic                         absence of construction debt. Commercial construction
lows. These low interest rates allow owners to refinance                          trends continue to post large year-over-year declines as
to greater proceeds than otherwise possible, and also yield                       of October 2010, while month-to-month declines are
additional net-of-interest-payment cash flow with which                           negative, but moderating. In real dollars, year-over-
to service tenant improvements and capital expenditure.                           year construction growth was down across the board:
     Assets with coverage ratios of 0.8-1.1x will go through                      32.8% ($10.7 billion) in the office sector; 39.6% ($24.6
some type of restructuring or sale that requires additional                       billion) in the industrial sector; 33.4% ($7.2 billion) in
equity capital. But many of these projects require more                           the multifamily sector; 10.3% ($2.8 billion) in retail; and
equity from day one, and it was only the misuse of cheap                          52.3% ($10.5 billion) in lodging.
and abundant debt that put this excess financing in place.                             The Linneman Construction Cost Index (LCCI) is
The day of reckoning for a poor capital structure is upon                         based on a hypothetical building consisting of lumber
the owners of these properties.
     The challenge is not too much debt per se; it is the                                                                            U.S. Commercial Construction
fact that valuations are sometimes overhyped. If values                                                                                           (Real - 2008 $)

then rationalize, equity adjusts instantly (e.g., most                                                       80
                                                                                                             70
internet start-ups). But debt allows endless argument over                         $ Billions                60
                                                                                                             50
rights and values. And the fact that banks are insured and                                                   40

under-capitalized due to the magic of fractional reserves,
                                                                                                             30
                                                                                                             20

and live off of mismatched investment spreads, make this                                                     10
                                                                                                              0
a matter of public policy. But over-valued is over-valued                                                         1995            1998        2001                  2004                 2007            2010

whether paid by debt or equity.                                                                                                   Office
                                                                                                                                  Hotel
                                                                                                                                                           Industrial
                                                                                                                                                           Multifamily
                                                                                                                                                                                           Retail



                                                                                  figure 209
Construction Costs
    Since 2006, public sector construction has increased
by about 30%. In contrast, private non-residential                                                                         Commercial & Industrial Construction Contracts
construction increased by nearly 50% from early 2006                                                             140
through 2008, but ended 2010 about 10% below 2006.
                                                                                       Millions of Square Feet




                                                                                                                 120

Meanwhile private residential construction has fallen by                                                         100
                                                                                                                  80
65% over the last four years.                                                                                     60
                                                                                                                  40
                                                                                                                  20
                                                                                                                   0
                      Construction Index – Broad Sector                                                            1963    1968     1973   1978     1983      1988         1993     1998         2003   2008
                                                                                                                                                                                             Source: McGraw Hill
 200

 150                                                                              figure 210
 100

     50
                                                                                                                          Ratio of C&I Construction Contracts to Real GDP
     0
      2006            2007           2008            2009        2010                            2.5
             Public          Private Non-Residential        Private Residential
                                                                                                 2.0

                                                                                                 1.5
figure 208
                                                                                                 1.0

                                                                                                 0.5

   After a brief rise to 31.7 million square feet of                                             0.0

commercial and industrial contracts awarded in December                                                          1969     1974      1979    1984       1989          1994         1999          2004    2009

2009, contracts have fallen to 21.1 million square feet in
                                                                                  figure 211
August 2010. We expect construction levels to remain

54
THE LINNEMAN LETTER
   Volume 10, Issue 4                                                                                                                                 Winter 2010-11

(5%), concrete (5%), gypsum (10%), iron and steel                                               trend. This has occurred, with recent declines pushing
(10%), labor (50%), and land (20%). We track the costs                                          the real cost index back down to historical norms.
of these components (except land) using producer price
indices from the U.S. Bureau of Labor Statistics. For                                                                  Producer Price Index
land, we set the 1995 base value to 100 and assume that                                         500
it has increased by CPI (all goods) over time. We add                                           400
up all of the nominal values of the component indices to                                        300

arrive at the nominal LCCI, which is converted to a real                                        200

basis using CPI.                                                                                100

    In comparison, the Turner Building Cost Index                                                 0

(TBCI), published by Turner Construction, tracks the                                                  1980      1985    1990        1995       2000      2005          2010
                                                                                                             Lumber      Concrete          Gypsum         Iron and Steel
overall cost of construction on a national basis, taking
into account major construction cost categories such                                            figure 214
as “material prices, labor rates, productivity, and the
competitive condition of the marketplace.” As with                                                   By the end of the third quarter of 2010, the real LCCI
the LCCI, we converted the TBCI to a real basis using                                           had declined by 2.1% over the last three years, and by
core CPI.                                                                                       1.3% quarter-over-quarter, although it increased by 1.2%
                                                                                                compared to the third quarter of 2009. On a year-over-
                            Construction Cost Indices
                                                                                                year basis, the gypsum producer price index declined
 250                                                                                            by 0.8%, and by 1.0% quarter-over-quarter through the
 225
 200                                                                                            third quarter of 2010. Current gypsum pricing reflects a
 175                                                                                            27% decline since its peak in the third quarter of 2006.
 150
 125                                                                                            The cost of iron and steel peaked in the second quarter
 100
  75
                                                                                                of 2008, dropped by 42% through the second quarter of
  50                                                                                            2009, and then rose 32% through the third quarter of
       1990            1994            1998
                          Linneman - Nominal
                                                           2002            2006
                                                             Linneman - Real
                                                                                         2010
                                                                                                2010. The lumber price index peaked in the third quarter
                          Turner - Nominal                   Turner - Real
                                                                                                of 2004. It declined by nearly 33% through the second
figure 212                                                                                       quarter of 2009, but increased by 8.9% over the last year.
                                                                                                Concrete prices have been on an upward trend for the
                                      Change in Cost Indices
                                                                                                last 20 years through mid-2009, but have declined since
                                         Through 3Q10                                           then. Neither the LCCI, nor the Turner Index, reflects the
                                                                                      20-Yr
                                           Y/Y              Q/Q          Over 3 Yrs   CAGR      enormous declines that have occurred in land prices.
 LCCI (Nominal)                            2.5%            -0.9%            2.8%       3.0%
 LCCI (Real)                               1.2%            -1.3%           -2.1%       0.4%
 Turner Index (Nominal)
 Turner Index (Real)
                                          -2.7%
                                          -3.9%
                                                            0.0%
                                                           -0.4%
                                                                           -7.5%
                                                                          -11.9%
                                                                                       3.0%
                                                                                       0.4%
                                                                                                Vacancy Rate Declines On The Horizon
 Lumber                                    8.9%            -5.8%           -6.2%       1.4%          Vacancy rates soared for almost every type of property
 Concrete                                 -1.2%             0.0%            3.1%       3.1%
 Gypsum                                   -0.8%            -1.0%           -3.6%       3.6%     over the past two years, with (Census) multifamily
                                                                                                vacancy rates rising from 10% to 10.4%, industrial rates
 Iron & Steel                             20.0%            -3.7%           11.0%       3.9%
 Labor (Benefits + Wages)                  0.6%             0.4%            7.5%       3.0%
 CPI (all items)                           1.3%             0.4%            4.9%       2.6%
                                                                                                rising from 8.3% to 12.9%, office vacancy rates rising
 Source: Bureau of Labor Statistics, Linneman Associates, Turner Construction                   from 11.7% to 15.5%, and retail vacancy rates rising from
figure 213                                                                                       7.5% to 11.0%. Meanwhile, Smith Travel Research’s
                                                                                                hotel occupancy rates declined from 65.5% to 55.8%.
     On a real basis, both the LCCI and the Turner Index                                        It should be noted that NCREIF data for institutional
exhibited 20-year compounded annual growth rates of                                             properties indicates that the multifamily sector bucked
just 0.4%. That is, construction costs have very slightly                                       the trend, falling from 8.2% to 6.2%.
exceeded CPI over the long run. Recall that three years                                              These weak property sector fundamentals reflect the
ago, when construction costs were surging by about 8%                                           loss of 8.4 million jobs during the recession, as well as
above trend, we warned that construction (and hence                                             a pipeline of new construction that added net new space
replacement) costs would revert back to their long-term                                         over the course of the recession. As a result, at the bottom

                                                                                                                                                                           55
THE LINNEMAN LETTER
        Volume 10, Issue 4                                                                                                                                                                      Winter 2010-11

of the recession, we were roughly 10 million jobs short
                                                                                                                                              U.S. Multifamily Vacancy Rates
of the rent and occupancy fundamentals that existed in
mid-2008. Since employment bottomed in December                                                                       12

                                                                                                                      10
2009, we have added nearly 1 million jobs, leaving us                                                                  8




                                                                                                            Percent
some 7.4 million jobs short.                                                                                           6

     Over the near term, nothing is being built, with                                                                  4

more square footage being destroyed than added to                                                                      2

the commercial real estate stock through 2012. As the                                                                  0
                                                                                                                       1956       1962     1968      1974     1980      1986     1992      1998      2004    2010
economy grows and jobs are added, vacancy rates will                                                                                                 Census                       Forecast

decline for all property types, much as occurred in the
                                                                                                        figure 217
early 1990s and early 2000s.
     Our statistical analysis of the impact of vacancy rates
indicates that a 100-bp increase in real GDP is historically                                                                                      U.S. Retail Vacancy Rates
associated with increasing vacancy, particularly in the                                                               12

hotel (-34 bps in occupancy), industrial (+33 bps in                                                                  10

vacancy), and office (+29 bps in vacancy) sectors. This                                                                8




                                                                                                           Percent
                                                                                                                       6
reflects the fact that development is pro-cyclical, so                                                                 4
historically when GDP increases, supply grows even                                                                     2
faster. However, this historic relationship will be muted                                                              0

over the next three years, as property values are well                                                                 1983       1986     1989    1992     1995     1998      2001     2004     2007     2010     2013


below replacement cost. Hence, even as GDP grows,                                                                                                     NCREIF                          Forecast


nothing will be built.                                                                                  figure 218
     The dominant influence will be employment growth,
where we find that a 100-bp increase in employment
reduces industrial vacancy rates by 72 bps, hotel vacancy                                                                                         U.S. Hotel Occupancy Rates
                                                                                                                      70

                                      U.S. Office Vacancy Rates                                                       65
                                                                                                          Percent




                                                                                                                      60
               20
                                                                                                                      55
               15                                                                                                     50
     Percent




                                                                                                                      45
               10
                                                                                                                           1988     1991      1994        1997       2000      2003       2006       2009        2012

                5                                                                                                                                 Smith Travel Research                        Forecast


                0
                1983   1986    1989     1992   1995     1998    2001    2004      2007   2010    2013
                                                                                                        figure 219
                                          NCREIF                       Forecast


figure 215                                                                                               rates by 53 bps, office vacancy rates by 43 bps, and
                                                                                                        multifamily and retail vacancy rates by 26 bps. Thus, if
                                                                                                        employment increases by 7-8% (9.7 million jobs) over
                                U.S. Industrial Vacancy Rates
                                                                                                        the next three years, we anticipate that office vacancy
                                                                                                        rates will decrease by about 320 bps, while multifamily
               20


               15                                                                                       and retail vacancy rates decline by approximately 200 bps
     Percent




               10                                                                                       and industrial vacancy rates fall by approximately 520
                                                                                                        bps. Hotel occupancy rates will increase by about 380 bps
                5
                                                                                                        in the face of such an employment rebound. There will
                0
                1987    1990     1993      1996       1999     2002     2005      2008    2011
                                                                                                        still be some distance to go before these markets have
                                          NCREIF                       Forecast
                                                                                                        regained full health, but if employment gains achieve the
                                                                                                        momentum we expect, vacancy rates will be far healthier
figure 216
                                                                                                        than at their current levels.

56
THE LINNEMAN LETTER
   Volume 10, Issue 4                                                                                                                                             Winter 2010-11

                                Vacancy Rates                                     China does not outperform (at least for the moment) our
                           2Q 2008              Worst           4Q 2013 Est.      more market-guided (at least for the moment) growth, as
 Office                      10.7                15.5               12.3
 Industrial                   6.9                12.9                7.7          their growth in a good year is about the same as ours in
 Multifamily
 Retail
                             10.0
                              6.7
                                                 11.1
                                                 11.0
                                                                     8.5
                                                                     9.0
                                                                                  a mediocre year.
 Hotel*                      62.5                54.7               60.9              On a purchasing power parity basis, China’s per
 Source: NCREIF, Census, Smith Travel Research, Linneman Associates               capita GDP grew by an astounding 2,278% in total, or
 *Hotel is for 12-month rolling occupancy.
                                                                                  12% on a compounded annual basis, between 1980 and
figure 220                                                                         2008 (latest available across countries), from $298 to
                                                                                  $5,970 (current dollars). Over the same period, India and
A New Giant                                                                       the U.K. showed the next greatest improvements, with
     With great fanfare, it was announced that China has                          nearly 600% and 325% total growth, respectively. Per
recently surpassed Japan as the world’s second largest                            capita GDP in the U.S. increased by 288% in total, or
economy. With GDP of approximately $5.4 trillion, it
remains a mere 36% of the U.S. economy, despite having                                                                                   Per Capita GDP
more than four times the population. Nonetheless, China’s                                           500
continued economic evolution causes many to say that                                                400
the U.S. should emulate its heavily government-guided

                                                                                    1980 = 100
                                                                                                    300

economy. But lost in the fanfare is the fact that Chinese                                           200

per capita GDP is only $4,000, versus U.S. per capita                                               100

GDP of approximately $47,700. If the Chinese economy                                                  0

grows at its target of 8% per annum, it represents annual                                                 1980           1985
                                                                                                                          U.S.
                                                                                                                                          1990
                                                                                                                                           Brazil
                                                                                                                                                      1995
                                                                                                                                                        Italy
                                                                                                                                                                2000
                                                                                                                                                                  France
                                                                                                                                                                            2005


growth of $432 billion, or $320 per capita. In marked                                                                            Germany            Japan       U.K.

contrast, even at the U.S. economy’s current rate of 2.5%                          figure 221
GDP growth, the U.S. will grow $370 billion or $716 per
capita. Given that per capita real GDP growth in the U.S.
historically runs closer to 1.75%, this means that U.S.                                                                                  Per Capita GDP
per capita GDP grows by approximately $835 annually,
                                                                                                    2,500
or 2.6 times (each year) as much as that in China. Stated                                           2,000
differently, while rapid growth in China is welcomed,
                                                                                       1980 = 100




                                                                                                    1,500
it should not be forgotten that far greater increases in                                            1,000
economic well-being are being created in the U.S. every                                              500

year, and that aggregate annual average growth in the                                                     0

U.S. ($407 billion) is approximately the same as what                                                         1980        1985             1990       1995      2000        2005
                                                                                                                                  U.S.              India          China
occurs when China grows at its target 8% ($432 billion).
That is, the vaunted government-guided economy of                                  figure 222


                                                        Change in GDP per Capita (US $, current prices, PPP)
                                                  1980-2008                                                          1998-2008                                  2003-2008
                                   Total Growth                 CAGR               Total Growth                              CAGR                       Total Growth         CAGR
 Brazil                                180%                      3.7%                  53%                                    4.3%                          36%              6.3%
 Italy                                 239%                      4.5%                  32%                                    2.8%                          15%              2.9%
 France                                248%                      4.6%                  45%                                    3.8%                          21%              3.8%
 Germany                               262%                      4.7%                  46%                                    3.9%                          24%              4.4%
 Japan                                 283%                      4.9%                  42%                                    3.6%                          24%              4.4%
 U.S.                                  288%                      5.0%                  49%                                    4.1%                          24%              4.3%
 U.K.                                  325%                      5.3%                  53%                                    4.3%                          19%              3.6%
 India                                 598%                      7.2%                 116%                                    8.0%                          63%             10.3%
 China                               2278%                      12.0%                 199%                                   11.6%                          86%             13.2%

 Source: OECD, Linneman Associates; CAGR = compounded annual growth rate over the indicated periods.

figure 223


                                                                                                                                                                                    57
THE LINNEMAN LETTER
        Volume 10, Issue 4                                                                                                                          Winter 2010-11

5.3% per year, over the same 28 years, from $12,153 to                                                   nearly 820,000 square feet in 2010 and 267,200 square
$47,186 on a purchasing power parity basis. In contrast,                                                 feet in the third quarter. The vacancy rate decreased to
of the countries shown in figure 223, Brazil (180% total,                                                16.9% (from 17.3%) in the second quarter, just over the
3.7% per annum), Italy (239%, 4.5%), and France (248%,                                                   national average of 16.6%. The average asking rate in
4.6%) experienced the least improvement in per capita                                                    the metro area was $19.99 per square foot, representing a
GDP since 1980.                                                                                          decline of 1.3% compared to the second quarter of 2010.
     In the last 10 years, China (199%, 11.6%) and India                                                 By the end of the third quarter of 2010, nearly 87,000
(116%, 8%) take the top spots in per capita GDP growth                                                   square feet were under construction. In comparison,
as well, while Brazil and the U.K. tie for third at 53%                                                  about 315,000 square feet were under construction in the
growth (4.3% per year) since 1998. Italy (32%) and Japan                                                 second quarter of 2010. New development will remain
(42%) were at the bottom end of the range in 10-year per                                                 constrained until vacancy falls considerably.
capita GDP growth.                                                                                            Benefitting from its status as the financial center of
                                                                                                         the Rocky Mountain region, Denver has a diversified
                                                                                                         job base. Denver’s largest employer is the government,
                                    U.S. Trade Deficit as a Percentage                                   including both federal and state workers. In addition,
                                    of U.S. & World GDP (net of U.S.)
                                                                                                         Denver ranks first out of all metropolitan areas for
               0.0
                                                                                                         private aerospace employment. Other large employers in
               -2.0
                                                                                                         the region include Lockheed Martin, United Airlines, and
     Percent




               -4.0

               -6.0
                                                                                                         IBM. The aggregation of high-tech industries results in a
               -8.0                                                                                      highly educated labor pool.
                    1992    1994      1996     1998
                           Deficit as % of U.S. GDP
                                                        2000    2002      2004    2006    2008    2010
                                                                 Deficit as % of Non-U.S. World GDP
                                                                                                              In previous issues we have discussed a covariance
                                                                                                         analysis that was published in the Spring 2007 Wharton
figure 224
                                                                                                         Real Estate Review. In that analysis, we examined
                                                                                                         how various economic indicators behave in individual
                                                                                                         metropolitan areas, based on national economic changes.
                                     Trade Deficit with Dollar Index                                     For each MSA, we calculated a “beta,” which summarizes
                1990         1993       1996          1999      2002      2005       2008                how a 100-bp change at the national variable affects the
               0                                                                                   140   local indicator. The beta for the U.S. as a whole is defined
               -1                                                                                  120
               -2                                                                                  100
                                                                                                         as 1. Thus, an MSA with a beta of 1 registers (on average)
  Percent




               -3                                                                                  80    an increase of 100 bps in employment growth (around
               -4
               -5
                                                                                                   60
                                                                                                   40
                                                                                                         its trend) when national employment rises by 100 bps.
               -6                                                                                  20    A beta that is less than 1 indicates that the MSA does
               -7
                               Trade Deficit as % of U.S. GDP                     Dollar Index
                                                                                                   0
                                                                                                         not boom (or bust) to as great an extent as the national
                                                                                                         economy, while a beta that is greater than 1 indicates that
figure 225                                                                                                such an MSA will experience swings of much greater
                                                                                                         magnitude (compared to the local trend) than the changes
    Over the last five years, China (86%, 13.2%) and                                                     at the national level.
India (63%, 10.3%) continue their steep ascent in per                                                         With an employment beta of 0.95, Denver’s
capita GDP, albeit from relatively low bases. With a 5-                                                  employment base responds with 5% less magnitude than
year growth rate of 36%, Brazil rounds out the top three,                                                national movement in employment level, though it is
while Germany, Japan, and the U.S. all had strong 5-year                                                 generally moving in step with the nation. This indicates
total growth of about 24%.                                                                               that the Denver economy is very closely correlated to the
                                                                                                         nationwide economy. Because of its highly diversified
Market Close-up: Denver Office                                                                            economy and added employment stability as a state
     Overview and Economy. The Denver office market                                                      capital, Denver was not as badly affected by the recession
was stable in the third quarter of 2010, showing signs of                                                as other metropolitan areas.
a slow recovery from the recession. The net absorption                                                        Denver payroll employment hit an all-time high in
rate has been positive for the last three quarters, reaching                                             the second quarter of 2008 at 1.17 million jobs, thereafter

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             Volume 10, Issue 4                                                                                                                             Winter 2010-11

                                                                                                                rate of 16.6%), from 17.3% in the prior quarter. The
                                         Denver Employment Forecast
                                           (net of construction employment)
                                                                                                                vacancy rate for Class A space fell to 13.4%, while the
             1.30                                                                                               vacancy rate remained higher for Class B and Class C
             1.25
             1.20
                                                                                                                space at 16.9% and 19.9%, respectively. West Hamp-
                                                                                                                Alameda had the highest vacancy rate of all submarkets
 Millions




             1.15
             1.10
                                                                                                                at 24.8%, while Boulder was the lowest at 11.2%.
             1.05
             1.00                                                                                                   Rental Rates and Leasing. Asking rents declined by
             0.95                                                                                               1.0% in the third quarter of 2010, to $19.99 per square
                     1999      2001      2003      2005      2007      2009       2011      2013       2015
                                                                              2010: 1Q-3Q Actual; 4Q Forecast   foot. Lease rates in Class A space decreased from $23.66
                                                                                                                to $20.43 per square foot in the third quarter, while Class
figure 226
                                                                                                                B and C rates increased to $18.13 and $15.12 per square
                                                                                                                foot, compared to $18.46 and $15.20 in the second
losing over 50,000 jobs through the third quarter of 2010.                                                      quarter of 2010.
Primary industries in Denver include aerospace, aviation,                                                           Major third quarter leases included: William
bioscience, broadcasting and telecommunications,                                                                Exploration and Production (105,683 square feet) at 1001
energy, financial services, and information technology.                                                         17th Street; Webroot Software (100,000 square feet) at
    Unemployment in the region bottomed at 3.4% in                                                              Central Park Tower, 385 Interlocken Crescent; the Social
May 2007, subsequently peaking at 8.7% in June of                                                               Security Administration (98,769 square feet) at 1001 17th
2009. Since then, rates have fluctuated roughly around                                                          Street; WildBlue Communications (98,445 square feet)
8.0%, hitting a low of 7.1% in November of 2009. The                                                            at 349 Inverness Drive South; the U.S. Bureau of Prisons
unemployment rate had risen to 8.4% by the beginning                                                            (90,750 square feet) at 11900 East Cornell Avenue; and
of 2010, and was 8.2% as of October 2010, compared to                                                           the U.S. Bureau of Transportation Statistics (82,000
the national unemployment rate of 9.6% in October and                                                           square feet) at 3005 Rocky Mountain Avenue.
9.8% in November.                                                                                                   Development/Construction Pipeline. At the end of
                                                                                                                the third quarter, the Denver office pipeline consisted of
                               Denver vs. U.S. Unemployment Rate
                                                                                                                only 87,000 square feet, representing a 72% decrease from
             12                                                                                                 the second quarter of 2010. Central Park Tower, the most
             10
                                                                                                                significant project completed in the third quarter, delivered
              8
                                                                                                                more than 285,000 square feet of Class A space to the
   Percent




              6

              4
                                                                                                                Northwest submarket. The construction pipeline will remain
              2
                                                                                                                subdued in subsequent months, but new development is
              0                                                                                                 expected to increase when vacancy nears 11%.
              1994      1996      1998          2000      2002      2004      2006       2008       2010
                                                Denver                 U.S.
                                                                                                                Submarket Review
figure 227                                                                                                       ß Southeast. At 33.5 million square feet, Southeast is the
                                                                                                                largest submarket in the MSA. The third quarter vacancy
    Absorption and Vacancy. In the third quarter, the                                                           rate was 18.0%, representing a decline of 20 bps from last
region’s office market registered 267,200 square feet of                                                        quarter. The average asking rate was $18.25 per square
positive net absorption, of which approximately 80%                                                             foot, compared to $18.56 in the second quarter of 2010.
was Class A space. However, approximately 50% of all                                                            ß West. With 86,581 square feet under construction, West
submarkets reported negative absorption. The regional                                                           was the only submarket that reported ongoing construction
office availability rate decreased by 40 bps to 23.8%                                                           in the third quarter. It also had the worst net absorption in
compared to the second quarter of 2010. Total rentable                                                          the region, at -88,826 square feet, compared to negative
areas increased slightly from 106.9 million in the second                                                       net absorption of 28,243 square feet in the second quarter.
quarter to 107.3 million, of which 2.8 million square feet                                                      The vacancy rate was lower than the regional average, at
were sublease space.                                                                                            16.5%. The asking rate was $18.55 per square foot in the
    The overall vacancy rate decreased by 40 bps to                                                             third quarter of 2010, maintaining the same level as the
16.9% in the third quarter (just over the national vacancy                                                      previous quarter.

                                                                                                                                                                             59
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                       Winter 2010-11

ß Downtown. Downtown is the second largest submarket,           weak until robust job growth returns. Disappointing
with 25.5 million square feet of rentable area. It also had     employment growth creates insufficient demand for office
the highest asking rate in the third quarter, at $26.15 per     space, particularly for Class B and C space, which has
square foot, representing a slight decline from $26.43          reported negative absorption. Demand will not improve
per square foot in the second quarter. Its vacancy rate         significantly in 2011.
was 15.4%, lower than the regional average, while its               However, based on its diversified employment base
availability rate was higher than average at 24.9%.             and more favorable key indicators than national averages,
                                                                we believe Denver will mount a solid recovery. In
    Investment and Sales. Denver office sales have              particular, Denver benefits from the growing healthcare
trended downward since 2007, hitting bottom in 2009 and         sector, which is the third largest in the metro area. The
recording a modest recovery in 2010. Total transaction          most encouraging news in the Denver office market in
volume was $521.8 million during the trailing 12 months         the third quarter of 2010 was that Fortune 500 kidney
through September 2010, representing an increase of 32%         care provider, DaVita, located its 270,000-square foot
from the same period the previous year. The third quarter       corporate headquarters in downtown Denver. This will
accounted for $121.1 million of transaction value, spread       hopefully represent the beginning of the restoration of
over 14 transactions.                                           corporate headquarters that were lost or downsized
    Cap rates have been relatively stable in 2010,              during the recession.
reaching 9.0% in the third quarter. In comparison, the
national average was 7.3%. The average price in the             Outlook
third quarter was $124 per square foot, compared to the             The market will remain stable through the fourth
national average of $210 per square foot.                       quarter of 2010. We forecast that the market will add
    Third quarter transactions saw an uptick. The most          about 38,000 new jobs by year-end 2011. From 2012
notable transaction was the sale of the former Urology          to 2014, we estimate that the Denver region will add
Center of Colorado at 2777 Mile High Stadium Circle in          approximately 110,000 jobs in the aggregate.
September. The 55,100-square foot facility sold for $23.3           The third quarter Denver office availability rate was
million ($422 per square foot). Other smaller transactions      23.8%. We expect it to decline slowly in the following
include: 8101 East Lowry Boulevard from Development             months. Our projections indicate that the availability rate
Solutions Group to Healthcare Realty Trust for $22.3            will reach 21.3% in 2011, 18.0% in 2012 and 15.7% by
million ($203 per square foot) in September; 2530 South         year-end 2013.
Parker Road from KBS Realty Advisors to Matrix Group
Inc. for $13.4 million ($64 per square foot) in July; and                                                Denver Office Market
1048 Pearl Street from E.W. Scripps & MediaNews                                     25.0                                                               800




                                                                                                                                                             Absorption (000’s SF)
Group to Karlin Real Estate for $9.0 million ($117 per                              20.0
                                                                                                                                                       700
                                                                 Vacancy Rate (%)




                                                                                                                                                       600
square foot).                                                                       15.0                                                               500

    Major sellers of office properties in the region over                           10.0
                                                                                                                                                       400
                                                                                                                                                       300
the past 10 years include Blackstone ($842.7 million in                              5.0
                                                                                                                                                       200
                                                                                                                                                       100
disposition, 11 properties), Equity Office Properties ($802.3                        0.0                                                               0
million in disposition, 13 properties), and Crescent RE                                    3Q10   1Q11     3Q11           1Q12       3Q12      1Q13

Equities ($683.4 million in disposition, 10 properties).                                                   Vacancy Rate          Absorption

    Major buyers of office properties in Denver over the        figure 228
past 10 years include Morgan Stanley ($1345 million in
acquisition, 12 properties), CPP Investment Board ($742
million in acquisition, 5 properties), Blackstone ($541.7       Market Close-up: St. Louis Industrial
million in acquisition, 5 properties), and CB Richard Ellis         Overview and Economy. The St. Louis industrial
Investors ($525.5 million in acquisition, 10 properties).       market witnessed a demand uptick during the third
    Opportunities and Challenges. The Denver office             quarter of 2010, with positive net absorption of more than
market has shown clear signs of recovery in the first three     370,000 square feet, ending the quarter with a vacancy
quarters of 2010, although fundamentals will remain             rate of 11% and availability of 16.6%. In comparison,

60
THE LINNEMAN LETTER
           Volume 10, Issue 4                                                                                                                                                 Winter 2010-11

the U.S. industrial availability rate ended the period at                                              to 9.6% for the U.S. The U.S. unemployment rate rose to
14%. Average rent for the St. Louis industrial sector was                                              9.8% in November.
$4.41 per square foot, representing a decline of $0.80
compared to the first quarter of 2010. This decline is
                                                                                                                                St. Louis vs. U.S. Unemployment Rate
occurring into the teeth of a planned construction pipeline                                                      12
of 5 million square feet from 2010-2013. However, the                                                            10
absence of construction capital will prevent most of these                                                        8




                                                                                                       Percent
developments from breaking ground.                                                                                6

    The top employers in the region are BJC HealthCare,                                                           4

Boeing, Washington University in St. Louis, SSM Health                                                            2

                                                                                                                  0
Care, Scott Air Force Base, Wal-Mart, Schnucks, USPS,                                                             1994   1996      1998   2000         2002   2004          2006   2008   2010
Mercy: St. John’s Mercy, and McDonalds. Overall,                                                                                           St. Louis                 U.S.

manufacturing activity in St. Louis has remained fairly
                                                                                                       figure 230
stable, while the service sector has shown modest
improvement in recent months. Employment in the
education and health services, other services, and                                                          Absorption and Vacancy. In the third quarter, the
government sectors has shown recent growth, while the                                                  region’s industrial market registered 370,690 square feet
financial activities, professional and business services,                                              of positive net absorption. This reflects the recent trend of
and information sectors have seen employment declines.                                                 companies expanding their industrial space usage during
    With an employment beta of 0.83 (see discussion                                                    a down (and inexpensive) market, while others maintain
in the Office Market Close-up), the employment base                                                    a “wait and see” philosophy. However, the availability
historically responds 17% less (around its mean) than                                                  rate in the St. Louis industrial market jumped from 16%
national trends. This means that both its boom and bust                                                in the first quarter of 2010 to 16.6% in the third quarter,
cycles are muted compared to the corresponding U.S.                                                    while the spread between availability and vacancy rates
trend.                                                                                                 rose by 80 bps to 560 bps. The overall year-to-date
                                                                                                       absorption is negative (-64,000) for the region, with half
                                St. Louis Employment Forecast                                          of all submarkets reporting negative absorption. There
           1.28
                                  (net of construction employment)
                                                                                                       is an additional 1.8 million square feet of direct space
           1.27                                                                                        available compared to the first quarter of 2010.
           1.26
                                                                                                            The overall vacancy rate declined by 20 bps to
Millions




           1.25
           1.24                                                                                        11% over the last quarter. The MSA’s vacancy rate has
           1.23
                                                                                                       maintained a 540-bp spread below the national average,
           1.22
           1.21                                                                                        compared to 700-800 bps during 2006 and 2007. Weak
                  1999   2001    2003    2005      2007     2009        2011       2013       2015     leasing continues, as the third quarter saw 279,000
                                                                     2010: 1Q-3Q Actual; 4Q Forecast
                                                                                                       square feet of velocity, 80% below the 3-year quarterly
figure 229                                                                                              average.
                                                                                                            Rental Rates and Leasing. Asking rents declined
     St. Louis Metro area non-construction payroll                                                     by 2.3% in the third quarter of 2010, to about $4.41 per
employment hit a ten year low in the first quarter of                                                  square foot, compared to $4.51 in the second quarter.
2010, at 1.21 million jobs, but has since gained 20,000                                                     Major third quarter leases included Centric (588,800
jobs through the third quarter of 2010. Primary industries                                             square feet) at 13257-13269 Corporate Exchange Drive
in St. Louis include health and education services,                                                    in Earth City; Whirlpool (556,287 square feet) at 65
government, business services, and retail. St. Louis metro                                             Corporate Woods Drive in Bridgeton; Cenveo Printing
area payrolls have gained 9,300 employees (0.72%) over                                                 (220,000 square feet) at 101 Workman Court in Eureka;
the last 12 months.                                                                                    Anheuser-Busch (184,800 square feet) at 6 Konzen Court,
     Unemployment in the St. Louis region hit a low of                                                 Granite City; Decoma (100,000 square feet) at 721 Prairie
4.6% in April 2007 before rising to a peak of 11% in                                                   DuPont Drive in Dupo; and Spartech (90,000 square feet)
March 2010. It stood at 9.3% in October 2010, compared                                                 at 11650 Lakeside Crossing Court in St. Louis.

                                                                                                                                                                                               61
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                    Winter 2010-11

     Major leases were relinquished by Visteon, which          ß South County. This submarket is moderately priced,
moved out of its facility in Eureka; Cenveo Printing,          with average rents of $4.82 per square foot in the third
which vacated 100,000 square feet, but moved into the          quarter, down 4.0% from year-end 2009. Vacancy was
Visteon Facility; and the Keefe Group, which vacated           moderate at 7.1%, down 60 bps from the first quarter of
700,000 square feet. Availability skyrocketed in 2009          2009.
when the Chrysler facility in Fenton shut down. The            ß St. Charles County. This submarket has a low vacancy
unused space initially consisted of 5 million square feet.     rate at 5.7%, showing no change from year-end 2009. It
     Development/Construction Pipeline. At the end of          is moderately priced, with average rental rates of $4.12
the third quarter, the development pipeline was over 5         per square foot, down 6.4% from the fourth quarter of
million square feet. With completion dates ranging from        2009.
the end of 2010 through 2013, most projects will not           ß Westport. This submarket has relatively high prices,
get off the ground in the next two years. Builders are         at $5.87 per square foot in the third quarter, down 4.2%
slated to deliver 560,690 square feet through 2010, with       from quarter four in 2009. Vacancy is 12.0%, down 70
the only scheduled industrial projects in Earth City and       bps from the first quarter of 2009.
North County.
                                                                   Investment and Sales. Tight capital markets have
Submarket Review                                               created financing challenges for both sellers and devel-
ß Central County. The third quarter vacancy rate was           opers, particularly for large properties. Sales velocity fell
9.1%, an increase of 30 bps year-to-date. This submarket       10.6% between the third quarter of 2008 and the third
has an average rental rate of $5.57 per square foot, a 7.8%    quarter of 2009. However, the search for yield caused
decrease from the fourth quarter of 2009.                      transaction volume to rise 22% in the past year, after re-
ß Chesterfield Valley. This is the highest priced              treating over 65% in the preceding year.
submarket, with average rents of $11.16 per square foot            Cap rates trended upwards in 2010, to an average
in the third quarter, up 17% from year-end 2009. Vacancy       of 10%. This is almost 200 bps over the 2007 level and
was 7.1%, down 370 bps from the first quarter of 2009.         equal to the previous peak in 2002.
ß Downtown. The third quarter vacancy rate was one of              Square footage sold declined due to a lack of large
the lowest of any submarket at 6.7%, showing no change         volume transactions. In August 2010, STAG Capital
year-to-date. This submarket had the lowest average            Partners and GI Partners purchased Herndon Products
rental rate at $3.31 per square foot, down just 30 bps         HQ in O Fallon for $5.1 million ($66 per square foot)
from the fourth quarter of 2009.                               from LK Drike LLC in a joint venture. Aside from the
ß Earth City. This submarket is a lower-priced market,         $433.7 million sale ($334 per square foot) of Chesterfield
with average rents of $4.23 per square foot in the third       Village by Pfizer to Monsanto in April 2010, the sale
quarter, up 1.9% from year-end 2009. Vacancy is at             of the Herndon Products HQ was the largest deal since
16.5%, up 640 bps from the first quarter of 2009.              12935 North 40 Drive was sold by Chapel Hill Partners to
ß Fenton. This submarket has the highest third quarter         Walker T&C LLC for $7.2 million ($169 per square foot)
vacancy rate at 47.7%, showing an increase of 80 bps           in December 2008. Other recent deals include Security
from the end of 2009. This submarket has higher average        Plaza from K. Gus Bontonis to Wothington Associates
rental rates at $6.84 per square foot, down 1.6% from the      for an undisclosed price, and 1400 N Price Road from
fourth quarter of 2009.                                        Murphy Co Mechanical Contractor and Engineers to TM
ß Metro East. This submarket is a low-priced market, with      Properties III LP for an undisclosed amount.
average rents of $3.70 per square foot in the third quarter,       Major sellers of industrial properties in the region
up 80 bps from year-end 2009. Vacancy was moderate at          over the past 10 years include TA Realty ($107.8 million
7.3%, down 110 bps from the first quarter of 2009.             in dispositions, 8 properties), Duke Realty ($62.3
ß North County. This submarket has a relatively high           million, 7 properties), First Industrial ($65.1 million,
vacancy rate at 12.8%, unchanged from year-end 2009.           6 properties), Panattoni Development ($88.9 million,
The submarket is moderately priced with average rental         3 properties), LaSalle Investment Management ($54.6
rates of $4.10 per square foot, up 70 bps from the fourth      million, 3 properties), and RREEF ($53.4 million, 3
quarter of 2009.                                               properties).

62
THE LINNEMAN LETTER
               Volume 10, Issue 4                                                                                                                            Winter 2010-11

     Major buyers over the last decade include TA Realty                                                           Market Close-up: San Diego Multifamily
($62.2 million, 7 properties), First Industrial ($93.2                                                                  Overview and Economy. The local cost differential
million, 6 properties), Cornerstone Equities LLC ($69.2                                                            between homeownership and renting remains large,
million, 5 properties), Cowen Capital Partners LLC ($50.8                                                          fueling rental demand. According to the National Multi
million, 5 properties), Blue Real Estate Management                                                                Housing Council, 51% of San Diego residents rent,
($50.8 million, 5 properties), and JB Realty Co ($55.3                                                             compared to the national average of 33%. The San
million, 4 properties).                                                                                            Diego multifamily market is one of the strongest in the
     Opportunities and Challenges. The recent economic                                                             country, having rebounded in recent quarters. Sustained
downturn has caused the coincident economic activity                                                               renter demand led to positive net absorption year-to-date,
index (measuring payroll employment, wages, and                                                                    lowering the vacancy rate 40 bps to 4.5% in the third
salaries) to fall 13% from January 2008 levels, versus a                                                           quarter. In comparison, the third quarter U.S. multifamily
6.4% decline for the U.S. as a whole. Companies remain                                                             vacancy rate stood at 10.3%. Regional asking ($1,311 per
hesitant to lease, while large blocks of industrial space                                                          month) and effective ($1,259 per month) rents increased
became available (78 spaces for 100,000 square feet in                                                             0.4% and 0.8%, respectively, over the first three quarters
St. Louis and St. Charles counties alone), increasing                                                              of 2010. In the past year, only 665 units have come
vacancy and driving down rents.                                                                                    online, increasing the rental stock by 0.4%. While more
     However, there has been growth within the manufac-                                                            than 1,000 units are in the pipeline, with 644 delivering
turing and industrial sectors in the area, with total man-                                                         in the fourth quarter, developers remain cautious in the
ufacturing employment increasing by 80 bps. Renewal                                                                face of steep land prices. With absorption positive for the
activity between existing tenants and landlords has be-                                                            last five consecutive quarters, the San Diego multifamily
gun to strengthen as long-term contracts are locked in at                                                          market fundamentals are robust.
the lower rates.                                                                                                        San Diego’s employment base is fairly diverse and
                                                                                                                   has weathered the recession fairly well. Defense has a
Outlook                                                                                                            strong presence in the region; the U.S. Navy is the top
    The market strengthened slightly through the fourth                                                            employer, and the U.S. Marine Corps has several bases
quarter of 2010, beginning a modest recovery. We forecast                                                          in the region. The region also has a strong technology
that the market will add about 18,000 jobs in the fourth                                                           sector, including Qualcomm, which was founded and
quarter of 2010, with an additional 16,000 new jobs by                                                             headquartered in San Diego. There is also a strong
year-end 2011. From 2012 through 2015, we estimate                                                                 education and healthcare sector, with the University of
that the region will lose approximately 7,000 jobs.                                                                San Diego and its state-run counterpart UCSD and their
    The third quarter industrial availability rate was                                                             accompanying hospitals among the largest employers
16.6%. By year-end 2010, we expect it to drop to 16.3%.                                                            in the region. Finally, tourism plays a large role in the
Our projections indicate that vacancies will continue a                                                            regional economy with national attractions such as the San
slow decline, reaching 15.0% by year-end 2011, 14.7%                                                               Diego Zoo. While tourism has not had a positive outlook
in 2012, and 15.01% by year-end 2013.                                                                              over the past several years, employment has improved
                                                                                                                   in the region, largely on the back of hiring spurts in the
                                                                                                                   logistical and professional and business services sectors.
                                     St. Louis Industrial Market
                                                                                                                        With an employment beta of 1.02 (see discussion in
                    17.0                                                           1,200
                                                                                                                   the Office Market Close-up), San Diego’s employment
                                                                                           Absorption (000’s SF)




                    16.5                                                           1,000
                                                                                                                   base moves roughly on par with national employment
 Vacancy Rate (%)




                    16.0                                                           800
                    15.5                                                           600                             trends.
                    15.0                                                           400
                    14.5                                                           200
                                                                                                                        San Diego MSA payroll employment hit a pre-
                    14.0                                                           0                               recession high in July 2007 at 1.31 million jobs (including
                    13.5                                                           (200)                           the construction sector). The recession caused this to drop
                           3Q10   1Q11   3Q11           1Q12       3Q12     1Q13
                                                                                                                   to 1.21 million jobs in December of 2009. San Diego has
                                         Vacancy Rate          Absorption
                                                                                                                   begun a slow recovery in 2010, gaining a total of 2,800
figure 231                                                                                                          jobs since January. The multifamily market has picked
                                                                                                                   up prior to sustained job growth, and will only continue

                                                                                                                                                                              63
THE LINNEMAN LETTER
            Volume 10, Issue 4                                                                                                                            Winter 2010-11

                                                                                                                asking rents to $1,624 per month. Class B/C buildings
                                      San Diego Employment Forecast
                                            (net of construction employment)
                                                                                                                improved to $1,120 per month, representing a 1.4% year-
            1.30                                                                                                over-year increase. Operator concessions such as free
            1.25                                                                                                rent periods are on the decline.
            1.20
                                                                                                                     Development/Construction Pipeline. With only 665
 Millions




            1.15
            1.10                                                                                                units brought online in the past year, new supply has
            1.05
            1.00                                                                                                been limited. More than 1,000 units are currently under
            0.95                                                                                                construction, with a 644-unit building scheduled for
                    1999      2001      2003       2005      2007     2009          2011     2013       2015
                                                                              2010: 1Q-3Q Actual; 4Q Forecast
                                                                                                                delivery in the fourth quarter. While the pipeline contains
                                                                                                                3,900 units in the planning stages, which would increase
figure 232
                                                                                                                multifamily stock by 2.2% in the region, none of these
                                                                                                                projects has a scheduled groundbreaking date. Multifamily
                               San Diego vs. U.S. Unemployment Rate
                                                                                                                permits issued year-to-date in the MSA increased by 6%
            12                                                                                                  (to 1,010), compared to the same period in 2009, indicating
            10
                                                                                                                a slight increase in projected upcoming supply.
             8
  Percent




             6

             4
                                                                                                                Submarket Review
             2                                                                                                  ß El Cajon/Santee/Lakeside. The third quarter vacancy
             0                                                                                                  rate in these eastern suburbs was the lowest in the region
             1994      1996          1998      2000
                                             San Diego
                                                          2002      2004
                                                                           U.S.
                                                                                  2006     2008      2010
                                                                                                                at 3.0%, a 100-bp decrease over the previous year.
                                                                                                                Effective rents were also the lowest for the region at
figure 233                                                                                                       $987 per month, a 1.1% year-over-year increase.
                                                                                                                ß Balboa Park/West of I-15. Rents are fairly low in this
to improve if the region can continue to recover the job                                                        central neighborhood. Effective rents for the third quarter
losses of the recession.                                                                                        stood at $994 per month, a 1% increase from last year.
    Unemployment in the MSA hit a low of 3.7% in                                                                Vacancy was also very low for the submarket at 3.2%,
December 2006, and peaked at 11.1% in January 2010.                                                             down 50 bps from the third quarter of 2009.
Since then, the rate has fallen to 10.2% in October 2010,                                                       ß National City/Chula Vista. This southern suburb
compared to 9.6% for the U.S. during the same period.                                                           boasted the third lowest vacancy rate in the region at
The U.S. rate rose to 9.8% in November, with a long way                                                         3.7%, down 30 bps year-over-year. Effective rents also
to go to reach pre-recession levels.                                                                            stood on the low end, at $1,128 per month, up 1.8% from
    Absorption and Vacancy. MSA multifamily vacancy                                                             September 2009.
has improved 40 bps year-to-date to 4.5%. This is a                                                             ß Oceanside. At the northern end of the San Diego metro
significant improvement compared to the first three                                                             area, near Carlsbad, this submarket had a vacancy rate of
quarters of 2009, during which vacancy climbed 90 bps.                                                          4.4%, down 30 bps since the third quarter of 2009. It was
The region has experienced positive net absorption for                                                          the only submarket to experience rental declines of -0.2%
the last five consecutive quarters, and vacancy is on a                                                         year-over-year, with rates standing at $1,167 per month.
downward trend in all submarkets. Class A vacancy fell                                                          ß Mission Bay/Pacific Beach. The old town of San Diego
60 bps to 5.6%, while second-tier properties saw vacancy                                                        was the only submarket to experience an increase in its va-
drop 40 bps to 3.8%. The regional vacancy rate stayed                                                           cancy rate, up 130 bps to 4.1%. As renters continue to seek
consistently lower than the national average through                                                            the lowest rates, the submarket will experience downward
the recession, with the current differential between San                                                        pressure on its rents, which increased by 4.1% year-over-
Diego and national vacancy rates standing at 650 bps.                                                           year to $1,490 per month (the most of any submarket).
    Rental Rates and Leasing. Year-to-date through
the third quarter of 2010, asking rents in the area have                                                             Investment and Sales. According to Real Capital
increased by 0.4% to $1,311 per month, while effective                                                          Analytics, sales activity fell 5% between the third quarter
rents improved by 0.8% to $1,259 per month. Year-over-                                                          of 2009 and the third quarter of 2010. However, in the
year gains for Class A buildings stood at 1.2%, bringing                                                        last two quarters, deal flow has improved 23% compared

64
THE LINNEMAN LETTER
   Volume 10, Issue 4                                                                                                                       Winter 2010-11

to the same period last year. The median price for             and another 24,000 jobs in 2011. From 2012 through
properties sold in the last year has also fallen to $110,000   2014, we estimate that the San Diego region will add
per unit, down 10% from 2009. Core assets have seen            approximately 81,000 jobs in aggregate.
great interest. The few class A deals that have been sold
have traded at cap rates in the low 6% range.                                                            San Diego Multifamily Market
     Third quarter overall transaction volume saw a large                           5.0                                                                 1,600

uptick from the previous quarter, primarily due to the $200                         4.0                                                                 1,400




                                                                                                                                                                Absorption (Units)
                                                                Vacancy Rate (%)
                                                                                    3.0                                                                 1,200
million ($294,000 per unit) sale of the Vantage Pointe                              2.0                                                                 1,000

building from Point of View to Equity Residential in Octo-                          1.0
                                                                                    0.0
                                                                                                                                                        800
                                                                                                                                                        600
ber. The property is a newly constructed, 42-story, 680-unit                       (1.0)                                                                400
                                                                                   (2.0)                                                                200
building that defines the core transactions attempted in the                       (3.0)                                                                0
area. The other major transactions from the quarter include                                3Q10   1Q11      3Q11      1Q12   3Q12         1Q13   3Q13

Raintree Partners’ acquisition of the 302-unit Trieste Vil-                                                  Vacancy Rate    Absorption

las in Mira Mesa from LaSalle Investment Management            figure 234
for $68.2 million ($226,000 per unit). This building traded
at a 5.0% cap rate. Finally, of note was the $22 million            The third quarter San Diego multifamily vacancy rate
($128,000 per unit) Security Properties Inc purchase of the    was 4.5%. By year-end 2010, we expect it to continue
172-unit Entrada building in central San Diego.                its downward trend to 4.3%. Our projections indicate
     Major sellers of multifamily properties in the            that vacancies will continue to decline to 2.4% in 2011,
region over the past 10 years include: Essex Property          hypothetically turning negative in 2012 and 2013. If we
Trust ($394.5 million, 28 properties); Archstone ($1.2         show negative vacancy rates, it simply means that given
billion, 21 properties); MG Properties ($160.7 million,        the scheduled supply and growth in expected demand,
13 properties); Fairfield Residential ($551.9 million, 8       sufficient demand pressure exists to more than absorb
properties); and ConAm ($154.9 million, 8 properties.          all available space. Of course, negative vacancies cannot
     Major buyers of multifamily properties in San Diego       occur, as in the face of such demand pressure additional
over the past 10 years include: Essex Property Trust           development will occur and rents will increase in order
($274 million, 22 properties); Pacifica Companies ($560        to dampen demand. Therefore, forecasts of negative
million, 21 properties); R&V Management Corp ($403.1           vacancy should be viewed as an indication of strong
million, 16 properties); and Maisel Presley Inc. ($249         excess demand.
million, 16 properties).
     Opportunities and Challenges. The San Diego               Market Close-up: Orlando Hotel
multifamily market is driven by demand caused by the                Overview and Economy. Orlando’s pleasant cli-
large divide between homeownership and rental costs.           mate, Disney/MGM/Universal presence, and relatively
While unemployment in the region has skyrocketed due           affordable housing drive the region’s long-term growth.
to the recession, this has only increased the number of        Orlando is the sixth largest city in Florida and the 27th
households seeking refuge in the rental market. With           largest MSA in the U.S. Orlando houses one Fortune
the construction pipeline cautiously low, vacancy rates        500 company and is home to Universal Orlando Resort
are trending downward with growing momentum.                   and SeaWorld Orlando. In addition, Lake Buena Vista,
Some suburban Class B/C submarkets even saw sub-               Florida, located 21miles southwest of downtown Orlan-
3% vacancy rates, which represent near full capacity.          do, is home to Walt Disney World. These attractions form
Landlords will be hard pressed not to reduce leasing           the backbone of Orlando’s tourism industry, making the
incentives in the next few quarters, as demand continues       area the third most visited American city.
to outpace supply in one of the strongest multifamily               With an employment beta (see discussion in the
markets in the country.                                        Office Market Close-up in this issue) of 1.35, Orlando’s
                                                               employment base responds 35% more (around its mean)
Outlook                                                        than any change in employment at the national level.
    We forecast that the market will continue its slow              At the end of 2000, employment in Orlando stood
recovery by adding 16,000 jobs in the fourth quarter           at about 853,000 jobs. Over the next seven years,

                                                                                                                                                                      65
THE LINNEMAN LETTER
           Volume 10, Issue 4                                                                                                                              Winter 2010-11

employment reached a high of just over 1 million jobs in                                                        past year through October 2010 at $56.60, again ranking
2007. Employment fell to 991,500 jobs by year-end 2008                                                          in the middle of the pack. Markets with comparable
and stood at a new low of 943,000 jobs as of the third                                                          RevPAR statistics include Denver ($58) and Phoenix
quarter of 2010.                                                                                                ($56).
    As the U.S. economy slowed in the face of the                                                                    Visitor Trends. Tourism is one of the region’s largest
recession, Orlando’s unemployment rate soared from its                                                          industries with 43.3 million domestic visitors and 3.26
May 2007 low point of 3.3%. Year-end unemployment                                                               million international visitors in 2009, according to the
rates in 2007, 2008, and 2009 were 4.3%, 8.8%, and                                                              Orlando/Orange County Convention and Visitors Bureau.
12.6%, respectively. The unemployment rate declined to                                                          For the large majority of overseas visitors, the main
11.1% in May 2010, and stands at 11.2%, significantly                                                           purpose of the trip was leisure/recreation/holiday (82.6%).
higher than the national unemployment rate of 9.8% in                                                           Top activities among overseas visitors included shopping
November 2010.                                                                                                  (92.2%), dining (83.8%), and visiting amusement/theme
                                                                                                                parks (83.0%). More than three-fourths (78%, 34 million)
                                        Orlando Employment Forecast                                             of domestic visitors traveled for leisure purposes, with
               1.2
                                          (net of construction employment)
                                                                                                                the remaining 22% (9.3 million) visiting for business.
               1.0                                                                                              Visiting a theme/amusement park was the most popular
               0.8                                                                                              activity among domestic leisure visitors (59%), while
    Millions




               0.6
                                                                                                                other popular activities included dining (44%), general
               0.4
               0.2
                                                                                                                entertainment (42%), and shopping (36%).
               0.0                                                                                                   Domestic leisure visitors spent an average of $499
                      1999      2001      2003      2005      2007     2009       2011       2013       2015
                                                                                                                per person per trip, or $1,433 per party per trip, while
                                                                              2010: 1Q-3Q Actual; 4Q Forecast
                                                                                                                overseas visitors spent approximately $852 per person
figure 235                                                                                                       per trip in Orlando, significantly less than the $963 per
                                                                                                                person in 2008. Total overseas visitor spending in Orlando
                                                                                                                during 2009 was an estimated $2.04 billion, down from
           14
                                  Orlando vs. U.S. Unemployment Rate
                                                                                                                $2.34 billion in 2008.
           12                                                                                                        Investment and Sales. The hotel investment market
           10                                                                                                   all but disappeared through the first half of the year, with
 Percent




               8
               6
                                                                                                                sales picking up in the second half of 2010. Hotel sales
               4                                                                                                are expected to remain active.
               2
                                                                                                                     According to Real Capital Analytics, the U.S. average
               0
               1994      1996          1998      2000       2002     2004       2006        2008       2010     hotel price was approximately $144,000 per room in
                                                  Orlando              U.S.                                     September 2010, a 3.3% year-over-year increase. In
                                                                                                                comparison, the average sale price for a hotel in Orlando
figure 236
                                                                                                                was about $59,000 per room, an increase of just 1.8%
    Hotel Market Statistics. Orlando’s hotel performance                                                        over the same period. RCA reported that the average U.S.
weakened slightly over the past year. According to Smith                                                        hotel cap rate was 7.8% and 7% in July and September
Travel Research (STR), running 12-month occupancy                                                               2010, respectively, while the average Orlando cap rate in
rates increased by 240 bps, rising from 59.8% in October                                                        July (latest available) was 12.6%.
2009 to 62.2% in October 2010. Of the 24 cities surveyed                                                             RCA reported that four sale transactions in the MSA
for highest occupancy rate, Orlando falls within the                                                            occurred in the third quarter of 2010. However, the market
bottom MSAs.                                                                                                    took off with 17 recorded transactions in October alone.
    STR reported that 12-month average room rates in                                                            In comparison, there were only 20 total transactions
Orlando decreased by 3.8% over the past year through                                                            recorded for the first six months of 2010.
October 2010, to $91.13 from about $94.80 in 2009.                                                                   One transaction occurred in July 2010: the 3-story,
Orlando ranks right in the middle of the MSAs in this                                                           103-unit Quality Inn & Suites at 5635 Windhover Drive
regard, sitting between Tampa ($92) and Minneapolis                                                             was acquired for $2.6 million (approximately $25,500/
($90.80). Running 12-month RevPAR was flat over the                                                             unit). No transactions were recorded in August, while

66
THE LINNEMAN LETTER
  Volume 10, Issue 4                                                                                                                     Winter 2010-11

three were recorded for September: the 8-story, 500-         will continue to feel pain well into 2011. Hotel investors
unit Ramada Gateway Hotel at 7470 W Irlo Bronson             should take advantage of predicted growth, though with
Memorial Highway sold for $9 million (approximately          caution, as the economy is still in pretty rough shape.
$18,000/unit); a 5-building, 814-unit Hilton located         Travel deals and packages should also continue to be
at 1751 Hotel Plaza Boulevard sold for about $127            offered in order to entice travelers, though pricing is
million (approximately $156,265/unit); and a 128-unit        showing early signs of strengthening. As of now, the best
Amerisuites at 7500 Augusta National Drive sold for          news for the industry is that the construction pipeline
$5.5 million (approximately$43,000/unit).                    has been constrained by tight lending standards, while
    Of the 17 October transactions, 11 were Extended         demand is rebounding from horrific lows.
Stay America Hotels across Orlando averaging about
$38,320/unit. Three transactions were Homestead Studio       Outlook
Suites, with the other three trades involving a Crossland        We expect Orlando hotel occupancy rates to rise over
Economy Studios, a Hampton Inn, and a Days Inn.              the next five years, hitting 65% by the end of 2011 and
    Major sellers of hotel properties in the region over     nearly 69% by year-end 2012. By year-end 2015, we
the past 10 years include Blackstone ($202.7 million, 16     expect occupancy to stand at 74.1%.
properties); Arbor Realty Trust, Chetrit Group, Lightstone       The long-term employment outlook is strengthening
Group, and Polar Trust (each with $66.2 million in           as well. By year-end 2011, we expect the metro area to
dispositions, 15 properties); and CNL Financial Group        support just over 1 million jobs. This is expected to grow
($1.3 billion, 8 properties).                                by about 45,000 jobs by year-end 2012, hitting about
    Major buyers of hotel properties in Orlando over         1.14 by year-end 2015.
the past 10 years include Blackstone ($640.2 million, 29
properties); Chetrit Group, Arbor Realty Trust, Lightstone                                              Orlando Hotel Market
                                                                                   72.0                                                           1,400
Group, and Polar Trust (each with $186.6 million, 15                               70.0
                                                              Occupancy Rate (%)




                                                                                                                                                          Absorption (Rooms)
                                                                                                                                                  1,200
properties); and Paulson and Company and Centerbridge                              68.0                                                           1,000
                                                                                   66.0
Partners (each with $66.2 million, 15 properties).                                 64.0
                                                                                                                                                  800

    Development/Construction Pipeline. According to                                62.0
                                                                                                                                                  600

                                                                                   60.0                                                           400
Lodging Econometrics, hotel completions in Orlando                                 58.0                                                           200
accounted for 1.3% of inventory in 2008, 4.3% in 2009,                             56.0                                                           0
                                                                                          3Q10   1Q11    3Q11        1Q12    3Q12         1Q13
and just 0.6% in 2010. Orlando is the largest hotel market
in the U.S., with a supply of approximately 123,000                                                       Occupancy Rate    Absorption


hotel rooms in about 490 hotels as of the third quarter      figure 237
of 2010.
    Eleven hotels with 1,530 rooms opened in 2008,
and 19 more (5,048 rooms) opened in 2009. According          Office Market Outlook
to Lodging Econometrics, three hotels with about 2,240           For the third quarter of 2010, 19 of the 42 U.S. office
rooms are currently under construction. Two hotels           markets we cover saw increasing vacancy rates, three
in each of 2011 and 2012 are scheduled for delivery,         remained flat, and 20 decreased. Of the metros with
accounting for just 0.3% of inventory.                       increasing rates, 10 increased by fewer than 100 bps,
    Our analysis assumes that only projects currently        with one metro growing by 20 bps and two by 30 bps.
under construction will be completed, though as of the       By the end of the third quarter of 2010, Detroit, West
third quarter of 2010, seven hotels (1,700 rooms) are        Palm Beach, the Inland Empire, and Phoenix exhibited
scheduled to start within the next 12 months, and nine       the highest vacancy rates, while Fort Worth displayed
hotels (1,300 rooms) are in the early planning stages.       the lowest vacancy rate, followed by New York City,
Despite this pipeline, few of these ventures will move       Charlotte, and Washington, D.C.
forward in the near term due to a lack of construction           By year-end 2010, we expect Detroit, Los Angeles,
financing.                                                   and Portland to see the greatest vacancy increases (of
    Opportunities and Challenges. Although the               20 bps), while San Francisco, Columbus, Chicago, and
recession has ended, the hotel industry is lagging and       New Jersey will increase by only 10 bps. The rest of

                                                                                                                                                           67
THE LINNEMAN LETTER
           Volume 10, Issue 4                                                                                                                                                    Winter 2010-11

the metros will either remain flat or will see decreasing
                                                                                                                                    Linneman Real Estate Index
vacancy rates, with West Palm Beach and Phoenix
                                                                                                         200                                                                                         20.0
leading the pack.




                                                                                                                                                                                                            Vacancy Rate (%)
    We do not expect market conditions to be in general




                                                                                     Index (4Q82 =100)
                                                                                                         150                                                                                         15.0

balance until at least 2013, when we foresee 40 markets                                                  100                                                                                         10.0

improving. By that time, the best markets are expected
                                                                                                          50                                                                                         5.0
to be Fort Worth, Orange County, Washington, D.C.,
and Seattle, while the worst markets will be Detroit,                                                      0                                                                                         0.0
                                                                                                           1980           1984          1988     1992          1996   2000     2004      2008
Cincinnati, and Northern and Central New Jersey.                                                                                 LREI             Industrial          Office          Multifamily
    Using a benchmark of 10% vacancy to proxy a
                                                                                    figure 239
relatively balanced market, no markets were in balance
as of year-end 2009, with only New York City in balance
as of the first quarter of 2010, and none in balance as of
the second or third quarters of 2010. Vacancy rates are                                                                   Multifamily and Commercial Mortgages Outstanding
expected to rise slightly through 2010. One market will                                                  3,500
                                                                                                         3,000
be in balance by the end of 2011, four markets will be in                                                2,500


                                                                                      $ Billions
balance by year-end 2012, and eight markets will be in                                                   2,000

balance through 2013.                                                                                    1,500
                                                                                                         1,000
                                                                                                           500

                         Vacancy Rates by Property Type                                                        0
           20                                                                                                      1997          1999          2001        2003    2005          2007         2009
                                                                                                                                               Multifamily      Commercial
           15
 Percent




                                                                                    figure 240
           10


            5
                                                                                    from 168 in the third quarter of 2009. The current LREI
            0                                                                       level indicates that the balance of commercial mortgage
            1983      1988
                       Office
                                 1993
                                    Retail
                                             1998           2003
                                                    Apartment
                                                                      2008
                                                                    Industrial
                                                                                    debt in the market exceeds demand for the space financed
                                                                   Source: NCREIF
                                                                                    by that debt by 52%.
figure 238                                                                                We have long said that property markets are over-
                                                                                    leveraged on a national level. The index has been
    The good news is that the Linneman Real Estate                                  increasing steadily since 1997, when it stood at 91. At
Index (LREI), which compares the fundamental demand                                 that time, the market had a capital shortage and vacancies
for space with the supply of real estate capital, finally                           were declining steadily. Previously, we indicated that the
reversed course in the third quarter of 2009, after a 12-                           LREI would fall in the face of the current credit crisis. In
year run-up. For our new subscribers, the supply of real                            fact, commercial debt outstanding has fallen precipitously,
estate capital (the numerator) is proxied by the aggregate                          but given the weak economy, corresponding GDP had
flow of commercial real estate debt, while the demand                               declined at a faster rate. As a result, the LREI continued
for space (the denominator) is proxied by nominal GDP.                              to increase through the second quarter of 2009, but
Excluding the net real estate equity flows from the                                 then finally reversed as GDP strengthened. We expect
numerator slightly understates an oversupplied market                               the LREI to continue to decline as the rebound in GDP
and overstates an undersupplied market. That is, this                               growth outpaces commercial mortgage lending.
index tends to understate capital oversupply situations.                                 In the third quarter of 2010, the national office
An index of 100 (base year = 1982) indicates that the                               vacancy rate dropped to 16.6%, a 10-bp decrease from
supply of real estate capital is roughly justified by the                           the previous quarter, according to CBRE. This puts U.S.
current demand for commercial space.                                                office vacancy above the “natural rate” of roughly 10%.
    In the third quarter of 2010, the Linneman Real Estate                          Severe job losses have resulted in increasing shadow or
Index (LREI) declined to 152, from its second-quarter                               sublease space, along with tenant inducements. These
level of 155. This was also a year-over-year decrease                               availabilities are expected to increase through 2010.

68
THE LINNEMAN LETTER
      Volume 10, Issue 4                                                                                                                                Winter 2010-11

                                                                            Office Vacancy Rates
                            Market                                3Q 2010 Act.       YE 2010 Est.             YE 2011 Est.          YE 2012 Est.               YE 2013 Est.
Atlanta                                                              22.4%              22.0%                   19.2%                 15.1%                      12.9%
Austin                                                               22.9%              22.4%                   18.4%                 13.4%                      10.6%
Baltimore                                                            17.5%              17.2%                   16.0%                 14.8%                      14.2%
Boston                                                               16.8%              16.6%                   15.8%                 15.2%                      14.8%
Charleston                                                           16.1%              15.7%                   12.4%                 10.0%                       8.9%
Charlotte                                                            14.4%              14.1%                   12.3%                 10.3%                       9.0%
Chicago                                                              17.0%              17.1%                   16.6%                 15.2%                      14.0%
Cincinnati                                                           24.1%              24.0%                   23.2%                 22.5%                      22.4%
Cleveland                                                            20.8%              20.3%                   19.3%                 19.0%                      18.9%
Columbus                                                             19.1%              19.2%                   19.2%                 18.6%                      18.0%
Dallas                                                               22.7%              22.2%                   19.7%                 17.6%                      16.7%
Denver                                                               23.8%              23.6%                   21.3%                 18.0%                      15.7%
Detroit                                                              30.0%              30.2%                   31.4%                 31.7%                      31.6%
Fairfield County                                                     23.5%              23.3%                   22.6%                 21.7%                      21.0%
Fort Lauderdale                                                      18.9%              18.5%                   15.7%                 12.1%                       9.9%
Fort Worth                                                           11.5%               11.1%                   8.4%                  5.5%                       3.6%
Houston                                                              18.5%              18.2%                   17.7%                 16.3%                      15.4%
Indianapolis                                                         23.2%              22.8%                   19.8%                 17.6%                      16.9%
Inland Empire                                                        28.5%              28.2%                   24.6%                 19.2%                      15.8%
Long Island                                                          18.1%              18.1%                   17.9%                 17.3%                      16.8%
Los Angeles                                                          18.0%              18.2%                   18.2%                 17.6%                      17.1%
Memphis                                                              16.8%              16.4%                   16.2%                 15.6%                      15.2%
Miami                                                                24.4%              24.1%                   21.6%                 19.2%                      18.3%
Minneapolis                                                          20.8%              20.6%                   19.6%                 18.1%                      16.9%
Nashville                                                            16.9%              16.8%                   15.4%                 13.1%                       11.5%
New York City                                                        13.5%              13.4%                   13.1%                 12.6%                      12.2%
North & Central NJ                                                   21.6%              21.7%                   21.9%                 22.1%                      22.2%
Orange County                                                        17.5%              16.9%                   12.0%                  6.7%                       4.5%
Orlando                                                              20.5%              20.0%                   16.0%                 10.9%                       8.0%
Philadelphia                                                         20.5%              20.4%                   19.8%                 19.0%                      18.4%
Phoenix                                                              25.9%              25.2%                   20.0%                 14.3%                      12.0%
Portland                                                             19.7%              19.9%                   20.1%                 19.0%                      17.6%
Raleigh-Durham                                                       21.2%              20.8%                   18.2%                 15.3%                      13.5%
St. Louis                                                            21.5%              21.3%                   20.1%                 19.9%                      20.2%
San Diego                                                            23.8%              23.6%                   22.1%                 19.8%                      18.3%
San Francisco                                                        18.6%              18.7%                   18.2%                 16.2%                      14.5%
San Jose                                                             20.8%              20.3%                   16.7%                 13.3%                      12.0%
Seattle                                                              19.3%              18.7%                   14.3%                  9.3%                       6.7%
Tampa Bay                                                            21.9%              21.5%                   18.2%                 13.1%                      10.0%
Washington, D.C.                                                     15.0%              14.4%                   10.9%                  7.7%                       6.3%
Westchester County                                                   21.3%              21.2%                   20.4%                 19.5%                      19.1%
West Palm Beach                                                      29.6%              28.8%                   24.1%                 19.5%                      17.4%

 Highlighted entries indicate market at supply-demand balance, or better.
 * Inland Empire = Riverside/San Bernardino Metropolitan Area
Note on Negative Vacancy: In order to calculate estimated vacancy rates, we adjust beginning inventory for new construction completions and compare that to net
absorption (including sublease space). If we show negative vacancy rates, it simply means that given the scheduled supply and growth in expected demand, sufficient
demand pressure exists to more than absorb all available space. Of course, negative vacancies cannot occur, as in the face of such demand pressure additional develop-
ment will occur and rents will increase in order to dampen demand. Therefore, forecasts of negative vacancy should be viewed as a strong excess demand indicator.

figure 241



                           U.S. Office Vacancy Rates                                                                U.S. Office Construction

            20                                                                                       40
                                                                                                     35
            15                                                                                       30
                                                                                                     25
  Percent




                                                                                        $ Billions




            10                                                                                       20
                                                                                                     15
             5                                                                                       10
                                                                                                      5
             0                                                                                        0
             1995   1998           2001       2004         2007             2010                      1995   1998           2001       2004             2007          2010
                            Grubb & Ellis               NCREIF
                                                                                                                       Nominal                 Real 2008 $


figure 242                                                                             figure 243



                                                                                                                                                                              69
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                           Winter 2010-11

                                                                             Industrial Vacancy Rates
                       Market                                 3Q 2010 Act.            YE 2010 Est.          YE 2011 Est.         YE 2012 Est.          YE 2013 Est.
 Atlanta                                                         14.4%                   13.9%                11.0%                 6.5%                  4.2%
 Austin                                                          21.3%                   20.8%                16.8%                 11.8%                 9.0%
 Baltimore                                                       19.0%                   18.7%                17.1%                15.7%                 14.8%
 Charlotte                                                       13.8%                   13.3%                11.3%                 8.9%                  7.3%
 Chicago                                                         11.4%                   11.5%                10.9%                 9.4%                  8.1%
 Cincinnati                                                      9.7%                     9.6%                 8.2%                 6.9%                  6.3%
 Cleveland                                                       9.9%                     9.4%                 8.3%                 8.1%                  8.1%
 Columbus                                                        13.0%                   13.1%                13.1%                12.4%                  11.7%
 Dallas-Fort Worth                                               11.9%                   11.4%                 8.4%                 5.8%                  4.9%
 Denver                                                          10.0%                    9.7%                 7.0%                 3.1%                  0.4%
 Detroit                                                         17.0%                   17.3%                18.6%                19.0%                 18.8%
 Fairfield County                                                22.1%                   21.9%                21.2%                20.3%                 19.6%
 Fort Lauderdale                                                 12.4%                   12.0%                 8.9%                 5.1%                  2.7%
 Houston                                                         10.6%                   10.2%                 9.5%                 7.9%                  6.7%
 Indianapolis                                                    12.1%                   11.7%                 8.6%                 6.3%                  5.8%
 Inland Empire*                                                  15.1%                   14.8%                10.5%                 4.2%                  0.1%
 Las Vegas                                                       13.4%                   13.1%                 9.7%                 4.9%                  1.9%
 Long Island                                                     4.9%                     4.9%                 4.7%                 4.0%                  3.3%
 Los Angeles                                                     7.6%                     7.8%                 7.9%                 7.2%                  6.7%
 Miami                                                           11.5%                   11.1%                 7.9%                 4.9%                  3.7%
 Minneapolis                                                     12.0%                   11.8%                10.7%                 9.1%                  7.8%
 Nashville                                                       14.9%                   14.8%                13.5%                 11.3%                 9.7%
 North & Central NJ                                              12.2%                   12.3%                12.6%                12.7%                 12.8%
 Orlando                                                         20.0%                   19.5%                15.4%                10.3%                  7.4%
 Philadelphia                                                    14.3%                   14.1%                13.5%                12.7%                 12.0%
 Phoenix                                                         18.3%                   17.5%                11.7%                 5.3%                  2.6%
 Portland                                                        8.7%                     8.9%                 9.1%                 7.8%                  6.2%
 St. Louis                                                       16.6%                   16.3%                15.0%                14.7%                 15.0%
 San Diego                                                       16.6%                   16.3%                14.4%                 11.7%                 9.8%
 San Francisco                                                   7.0%                     7.2%                 6.6%                 4.4%                  2.4%
 Seattle                                                         11.2%                   10.5%                 5.5%                 -0.2%                 -3.1%
 Tampa Bay                                                       13.1%                   12.7%                 9.0%                 3.4%                  0.0%
 Washington, D.C.                                                15.1%                   14.5%                11.0%                 7.7%                  6.2%
 Westchester County                                              11.4%                   11.3%                10.4%                 9.4%                  9.0%

 Highlighted entries indicate market at supply-demand balance, or better.
 * Inland Empire = Riverside/San Bernardino Metropolitan Area
 Note on Negative Vacancy: In order to calculate estimated vacancy rates, we adjust beginning inventory for new construction completions and compare that to net
 absorption (including sublease space). If we show negative vacancy rates, it simply means that given the scheduled supply and growth in expected demand, sufficient
 demand pressure exists to more than absorb all available space. Of course, negative vacancies cannot occur, as in the face of such demand pressure additional develop-
 ment will occur and rents will increase in order to dampen demand. Therefore, forecasts of negative vacancy should be viewed as a strong excess demand indicator.

figure 244


Industrial Market Outlook                                                                   In the third quarter of 2010, 18 markets saw increased
     According to CBRE, the U.S. industrial vacancy                                    vacancy and one remained flat, with the rest decreasing
rate decreased by 10 bps from the second quarter                                       by as much as 310 bps. The greatest improvements came
of 2010 to 14% in the third quarter of 2010. The first                                 from Long Island (-310 bps) and San Francisco (-150
quarter of 2009 registered a short-lived decline – the first                           bps), followed by Cincinnati and the Inland Empire
since 2006. In comparison, NCREIF’s U.S. industrial                                    (-60 bps each). The highest increases in vacancy were in
vacancy rate (primarily representing institutional-quality                             Charlotte (580 bps), Fort Lauderdale (270 bps), Nashville
properties) rose from 9.9% in the second quarter of 2010                               (180 bps), and Seattle (140 bps), with all other increases
to 12.9% in the third quarter of 2010. The two data series                             by 110 bps or less. At the end of the third quarter of 2010,
moved in lockstep from 1987-2004. The NCREIF series                                    the highest vacancy was in Fairfield County at 22.1%;
subsequently trended downward more sharply, but has                                    the lowest was in Long Island at 4.9%.
changed course over the last three quarters. This initial                                   By 2013, 32 of the 34 markets we cover are projected
divergence indicates that the institutional grade properties                           to improve. Compared to the third quarter of 2010,
in the NCREIF survey enjoyed greater demand than the                                   Phoenix (-1,570 bps), the Inland Empire (-1,500 bps),
overall market, but are now being affected by the far-                                 and Seattle (-1,430 bps) are expected to show the greatest
reaching economic downturn.                                                            improvements. Detroit is expected to experience the

70
THE LINNEMAN LETTER
     Volume 10, Issue 4                                                                                                                                                         Winter 2010-11

largest increase (180 bps) in vacancy rate, followed by                       higher quality than the Census properties. Thus, better-
Northern and Central New Jersey (60 bps).                                     quality properties are exhibiting better fundamentals.
    Using a 6% benchmark vacancy rate to proxy supply-                        During the recession, the Census vacancy rate has been
demand balance for industrial markets, no markets were                        relatively flat, but it increased 100 bps in the second and
in balance for the first quarter of 2010, none were in                        third quarters of 2009. In contrast, the NCREIF series
balance for the second quarter, and Long Island came                          exhibited a sharp increase from early 2006, as unsold
into balance for the third quarter. By year-end 2011, two                     high-end condos were converted to rental units. The
markets will be in balance, with nine more coming into                        decline starting in early 2009 indicated that the condo
balance by year-end 2012. Thirteen of the 34 markets are                      market overhang began to subside.
expected to be in balance by the end of 2013. Fairfield                           Multifamily starts (5+ units) have declined signifi-
County, Detroit, and St. Louis are projected to have the                      cantly to 137,000 in the third quarter of 2010, versus
highest vacancy levels in 2013, while Seattle, Tampa                          20- and 40-year averages of 395,000 and 429,000 units,
Bay, and the Inland Empire are projected to have the                          respectively. This reflects the confluence of weak reces-
lowest vacancy levels.
                                                                                                                                       U.S. Multifamily Vacancy
                         U.S. Industrial Vacancy Rates
                                                                                          12
                20                                                                        10

                15                                                                               8

                                                                                Percent
  Percent




                                                                                                 6
                10
                                                                                                 4

                 5                                                                               2
                                                                                                 0
                 0                                                                                       1980            1984          1988    1992      1996          2000      2004      2008
                 1990   1994         1998      2002            2006    2010                                                      U.S. Census Bureau                      NCREIF
                                  CBRE          NCREIF

                                                                              figure 247
figure 245


                          U.S. Industrial Construction
                                                                                                                         New Condominium Completion & Absorption
                80                                                                                             100




                                                                                                                                                                                                  Thousands Completed
                                                                                          Absorption Percent




                                                                                                                                                                                            100
                70
                                                                                                                80
                                                                                                                                                                                            80
                60
   $ Billions




                                                                                                                60
                                                                                                                                                                                            60
                50
                                                                                                                40                                                                          40
                40
                                                                                                                20                                                                          20
                30
                                                                                                                 0                                                                          0
                20
                                                                                                                  1995     1997        1999   2001    2003      2005     2007      2009
                 1995   1998         2001      2004           2007    2010
                                                                                                                          90-Day Absorption Rate             Completions, Trailing 4 Quarters
                               Nominal          Real 2008 $


figure 246                                                                     figure 248



Multifamily Market Outlook                                                                                                 Percentage of New Units Intended for Sale in
    The Census Bureau’s quarterly Housing Vacancy                                                                                      Multi-Unit Buildings

Survey indicates that the U.S. multifamily vacancy                                          60
                                                                                            50
rate remained stable in the third quarter of 2010 at                                        40
                                                                               Percent




10.3%. This series has generally been hovering around                                       30

10% since late 2003. For NCREIF’s more institutional                                        20

properties, the national vacancy rate increased by 36 bps,                                  10
                                                                                                        0
from 5.85% in the second quarter to 6.21% in the third                                                         2000             2002          2004           2006               2008            2010
quarter of 2010. This discrepancy in vacancy rates is due
to the fact that the NCREIF properties are generally of                       figure 249



                                                                                                                                                                                                                        71
THE LINNEMAN LETTER
         Volume 10, Issue 4                                                                                                                         Winter 2010-11

                                                                          Multifamily Vacancy Rates
                            Market                                   3Q 2010 Act.        YE 2010 Est.         YE 2011 Est.          YE 2012 Est.          YE 2013 Est.
Atlanta                                                                 10.5%               10.1%                7.1%                  2.7%                  0.5%
Austin                                                                  8.2%                 7.6%                3.2%                  -2.4%                 -5.4%
Baltimore                                                               6.0%                 5.2%                2.6%                  -0.8%                 -2.5%
Boston                                                                  6.2%                 6.0%                5.3%                  4.7%                  4.5%
Charlotte                                                               10.5%               10.2%                8.9%                  7.3%                  6.5%
Chicago                                                                 6.1%                 6.2%                5.7%                  4.2%                  2.9%
Cincinnati                                                              6.9%                 6.7%                5.3%                  3.9%                  3.3%
Cleveland                                                               6.1%                 5.6%                4.4%                  4.1%                  4.0%
Dallas-Fort Worth                                                       7.9%                 7.4%                4.6%                  2.2%                  1.5%
Denver                                                                  5.2%                 5.0%                2.4%                  -1.5%                 -4.0%
Detroit                                                                 7.1%                 7.4%                9.2%                  9.8%                  9.7%
Houston                                                                 11.5%               11.2%               10.6%                  9.1%                  8.2%
Indianapolis                                                            9.6%                 9.2%                6.1%                  3.8%                  3.3%
Inland Empire*                                                          7.1%                 6.8%                2.4%                  -4.4%                 -8.6%
Los Angeles                                                             4.9%                 5.2%                5.3%                  4.7%                  4.2%
Miami                                                                   5.9%                 5.4%                2.2%                  -1.0%                 -2.2%
Minneapolis                                                             4.3%                 4.2%                3.1%                  1.5%                  0.3%
New York City                                                           2.7%                 2.8%                2.9%                  2.9%                  2.9%
Orlando                                                                 9.8%                 9.3%                5.0%                  -0.4%                 -3.3%
Philadelphia                                                            5.7%                 5.6%                5.1%                  4.4%                  3.9%
Phoenix                                                                 10.3%                9.5%                3.5%                  -2.9%                 -5.4%
Portland                                                                4.8%                 5.1%                5.7%                  4.7%                  3.4%
St. Louis                                                               8.0%                11.5%               10.1%                  9.9%                 10.2%
San Diego                                                               4.5%                 4.3%                2.4%                  -0.4%                 -2.3%
San Francisco                                                           4.8%                 5.0%                4.7%                  2.6%                  0.9%
San Jose                                                                3.9%                 3.4%                -0.5%                 -3.9%                 -5.0%
Seattle                                                                 6.3%                 5.7%                1.1%                  -4.2%                 -6.6%
Tampa Bay                                                               8.6%                 8.2%                4.5%                  -1.2%                 -4.6%
Washington, D.C.                                                        5.4%                 4.8%                1.1%                  -2.2%                 -3.7%

Highlighted entries indicate market at supply-demand balance, or better.
* Inland Empire = Riverside/San Bernardino Metropolitan Area
Note on Negative Vacancy: In order to calculate estimated vacancy rates, we adjust beginning inventory for new construction completions and compare that to net
absorption (including sublease space). If we show negative vacancy rates, it simply means that given the scheduled supply and growth in expected demand, sufficient
demand pressure exists to more than absorb all available space. Of course, negative vacancies cannot occur, as in the face of such demand pressure additional development
will occur and rents will increase in order to dampen demand. Therefore, forecasts of negative vacancy should be viewed as a strong excess demand indicator.

figure 250


                                                                                        As labor markets improve and we start to add jobs, these
                            Multifamily Unit Construction
                                                                                        young people will move into their own space, absorbing
                 80
                 70                                                                     the empty units. The lack of construction means that
                 60
                                                                                        excess inventory is being absorbed.
     Thousands




                 50
                 40
                 30
                                                                                             For the third quarter of 2010, multifamily vacancy
                 20                                                                     rates improved in 24 of our 29 markets. The biggest
                 10
                  0                                                                     improvements came from Dallas-Fort Worth and Austin
                  2000   2002          2004    2006           2008        2010
                                                                                        (-140 bps each), with the rest decreasing by 120 bps or
                            Built For Sale        Built For Rent
                                                                                        fewer. Four markets remained flat, with only New York
figure 251                                                                               City increasing its vacancy rate, by 90 bps.
                                                                                             The highest vacancy rates for the third quarter of
sionary demand (due to doubling up of households), an                                   2010 were found in Houston, Charlotte, Atlanta, and
absence of construction financing, and a 10.3% vacancy                                  Phoenix, while New York City, San Jose, Minneapolis,
rate. We anticipate that multifamily starts will remain                                 and San Diego experienced the lowest rates. By 2013,
weak well into 2010, in the face of continuing soft de-                                 the laggards are expected to be St. Louis, Detroit, and
mand and a dearth of construction debt.                                                 Houston, while the Inland Empire, Seattle, and Phoenix
    The lack of construction is not such a horrible problem                             will boast the lowest vacancy levels.
in the near term (unless you are a developer), because                                       Using a 5% vacancy rate proxy for supply-demand
there is a fair amount of vacancy due to the fact that when                             balance, four of our markets were in balance at the end of
the economy shed jobs, people doubled up households.                                    the second quarter 2010, with three more coming into bal-

72
THE LINNEMAN LETTER
                   Volume 10, Issue 4                                                                                                                                                              Winter 2010-11

ance in the third quarter for a total of seven. By year-end                                                                                   with the analysis outlined earlier in this issue, which
2010, six markets are expected to be in balance. By 2013,                                                                                     indicates that the cumulative 6-year housing formation
we project that 25 of our 29 markets will be in balance.                                                                                      shortfall is approximately 2.2 million.
     To a large degree, the sector’s high vacancy rates                                                                                            As consumer confidence returns and job formation
reflect the fact that as the economy plunged, household                                                                                       resumes, these people will form their own households,
formation rates also plunged. Simply stated, when jobs                                                                                        leading to a surge in housing demand. As a result, we
are lost, young people double up either with families                                                                                         are bullish on the long-term investment prospects for
or friends, forestalling household formation. In 2008,                                                                                        multifamily housing. In addition, given the sector’s short-
2009, and 2010, household formations were 772,000,                                                                                            term leases, the multifamily sector will be able to best
398,000, and 419,000, respectively, versus a norm of 1.1-                                                                                     combat rising debt costs should the economy experience
1.2 million per annum. This means that there is a pent-                                                                                       a severe inflationary spike.
up demand of roughly 2 million households, of which                                                                                                Through 2011, we expect aggregate demand growth
approximately one-third will flow into multifamily, and                                                                                       to be about 762,000 units, with no net increase in supply.
two-thirds into single-family housing. This is consistent                                                                                     Thus, the current excess vacancy of 1.2 million multifam-
                                                                                                                                              ily units will fall to about 270,000 units, leaving the mul-
                                                                                                                                              tifamily vacancy rate at roughly 7.5% by mid-2012.
                                               U.S. Multifamily Housing Starts & Permits
                        1,400
                        1,200                                                                                                                 Retail Market Outlook
                        1,000
                                                                                                                                                  At 10.95%, NCREIF’s third-quarter 2010 retail
 Thousands




                         800
                         600                                                                                                                  vacancy rate rose from 10.1% in the second quarter, and
                         400
                         200
                                                                                                                                              was 19 bps higher than one year earlier. The vacancy
                                 0                                                                                                            rate broke 6% in the second quarter of 2008, for the first
                                 1964     1969      1974      1979
                                                              Starts
                                                                       1984    1989
                                                                                 Permits
                                                                                        1994      1999       2004      2009
                                                                                                                                              time since 1999. It is important to note that much of this
                                                                                                                                              retail vacancy exists in centers built to service residential
figure 252                                                                                                                                     communities that never materialized in the outer reaches
                                                                                                                                              of markets like Las Vegas and Phoenix. They were
                                                                                                                                              built in anticipation of a soon-to-be thriving residential
                                                    U.S. Multifamily Construction                                                             community, but as reality set in and home building
                        70
                        60
                                                                                                                                              ceased, these centers are now serving communities 60-
                        50                                                                                                                    90% smaller than anticipated. This type of vacancy
 $ Billions




                        40
                                                                                                                                              stands in contrast to rising vacancy in established market
                        30
                        20                                                                                                                    areas, which is occurring to a lesser degree.
                        10
                                                                                                                                                  The University of Michigan consumer confidence
                         0
                          1993          1995       1997     1999       2001     2003    2005          2007      2009                          index dropped to 67.7 in October 2010, compared to its
                                                           Nominal               Real 2008 $
                                                                                                                                              low of 55.3 in November 2008. The index had not seen
                                                                                                                                              the low of 2008 since 1980. Real retail sales peaked in
figure 253
                                                                                                                                              November 2007 at $349 billion, dropped to $300 billion

                                               Multifamily Construction and Vacancy Trends                                                                                  U.S. Retail Vacancy
                        350                                                                                            11
                                                                                                                                                         12
   Thousands of Units




                                                                                                                            Vacancy Percent




                        300                                                                                            10
                        250                                                                                            9                                 10
                        200                                                                                            8                                  8
                                                                                                                                               Percent




                        150                                                                                            7                                  6
                        100                                                                                            6
                                                                                                                                                          4
                         50                                                                                            5
                             0                                                                                         4                                  2

                             1990       1992    1994   1996    1998    2000   2002    2004     2006   2008 2010Q1                                         0
                                               Total in Bldgs w/ 5 or More Units (Thousands)                 Vacancy                                          1995   1998       2001        2004   2007      2010



figure 254                                                                                                                                     figure 255


                                                                                                                                                                                                                    73

				
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