A Special Research Report

Fourth Quarter 2011 Real Estate Investment Outlook

Market Turbulence Fails to Sway Real Estate Confidence

Investor sentiment remains high despite economic and political headwinds.
InvEsTOR sEnTIMEnT REcEdEs MOdERaTEly acROss PROPERTy TyPEs
The NREI/Marcus & Millichap Investor Sentiment Index fell back to 152 in the fourth quarter. It dropped 12 percentage points from the second quarter and is in line with the mark of 152 in the fourth quarter of 2010. Apartments recorded the highest index rating with a score of 163 (down from 166 in Q2), followed by hotels at 144 (down from 158), mixeduse at 126 (down from 139), industrial at 125 (down from 140), retail at 119 (down from 135) and office at 110 (down from 123). Since 2004, National Real Estate Investor and Marcus & Millichap Real Estate Investment Services have conducted research on investor attitudes and expectations as part of a commercial real estate industry forecast. Research gathered on views related to anticipated changes in property values, as well as plans to increase or decrease total real estate holdings over the next 12 months, provides the foundation for the investor sentiment index.

FIguRE 1. cOMMERcIal REal EsTaTE InvEsTOR sEnTIMEnT IndEx

200

150

100

100=Neutral

50

50
2004 2005 2006 2007 2008 2009 1Q10 3Q10 4Q10 2Q11 4Q11

ommercial real estate investors have not been dissuaded by the economic and political turmoil that has dominated headlines in recent months. The latest NREI/Marcus & Millichap Investor Sentiment Survey shows only a slight decline in investor sentiment from the high of 164 that was recorded in the second quarter. It is important to note that the current investor sentiment matches the 152 recorded in fourth quarter 2010, which at that time represented the highest level the index had achieved since the survey began in 2004 [Figure 1]. Investors have remained relatively steadfast despite being bombarded by a wave of macroeconomic and political troubles, including the ongoing debt crisis in Europe, the political logjam in Washington and the downgrade of the U.S. credit rating, among other concerns. Much like the economic data that we have seen come out over the past month, the survey data shows a pretty high degree of resilience, says Hessam Nadji, a senior vice president and managing director at Marcus & Millichap in Calabasas,

Survey Methodology
In October, National Real Estate Investors research unit and Marcus & Millichap e-mailed invitations to participate in an online survey to public and private investors and developers of commercial real estate. Recipients of the survey included Marcus & Millichap clients as well as subscribers of NREI and Retail Traffic selected from commercial real estate investor, pension fund, and developer business subscribers who provided their e-mail addresses. The majority of respondents are private investors (36%), developers (17%) and private partnerships (16%) with an average of $40.4 million invested in commercial real estate. REITs and institutional investors represent 7% of all respondents. The survey yielded 591 valid responses.

Fourth Quarter 2011 Real Estate Investment Outlook

Fourth Quarter 2011 Real Estate Investment Outlook

FIguRE 2. dRIvERs OF cOMMERcIal REal EsTaTE InvEsTMEnTs

Commercial real estate offers favorable returns relative to other investment classes We have an abundance of capital ready to invest I believe commercial property values have bottomed out I believe commercial property occupancies have bottomed out This is a good time to invest in public REIT stocks It would be better to invest in the stock market given the recent correction
0% Strongly agree Somewhat agree 20% Neither agree nor disagree 40% Somewhat disagree 60% Strongly disagree

To what extent do you agree or disagree with the following statements?

investors. Wall Street gave investors a wild ride in the past 90 days with the Dow Jones Industrial Average swinging more than 1,500 points, 13% of its total value. In that vein, 73% of respondents agree that commercial real estate offers favorable returns relative to other investment classes. In addition, only 8% say that it would be better to invest in the stock market, given the recent market correction, compared to 71% who do not agree with that assessment and 21% who have no opinion.

Apartments dominate
80% 100%

Base: respondents to the 4Q 2011 study (591).

Calif. There is no sense of panic that is reflected in the economic data or this survey, adds Nadji. That confidence is supported by activity in the broader economy, which continues to move forward, albeit at much slower pace than most would like. Job growth in August, September and October beat expectations with 241,000 private sector jobs added in September and October. Retail sales, excluding auto and gas, also beat expectations with a year-over-year increase of 6.1%, in October, according to the U.S. Department of Commerce. Collectively, what this is showing us is that the economy is not growing very fast, but there is confidence and reconfirmation that both the economy and commercial real estate have regained solid footing, says Nadji. Despite the sustained confidence, re-

spondents to the NREI/Marcus & Millichap fourth-quarter survey voiced significant concerns related to the direction the economy is headed in and the impact it will have on capital markets. Overall, 44% of respondents believe the U.S. economy will stagnate, but will not fall into recession. However, nearly one in three respondents, 31%, believes the U.S. economy is already in a recession, and another 15% say that the economy is headed into a recession in the next 12 months. In addition, 38% of respondents think that the European debt crisis will cause widespread capital markets problems, and 32% say that the handling of the debt ceiling/U.S. debt downgrade will lead to disruptions in the capital markets. Ironically, some of the uncertainty in the market may actually be boosting the appeal of commercial real estate to

Investor sentiment remains positive despite a significant divide related to views on the outlook for both property values and occupancies. Opinions are split on whether or not the commercial real estate market has hit bottom or still has further erosion ahead. Overall, 45% of respondents believe values have not yet hit bottom, while 38% agree that values have reached their low point. The remaining 17% are either on the fence or have no answer. Respondents were slightly more optimistic on occupancies with 42% stating that commercial property occupancies have bottomed out. More than one-third of investors, 39%, say that occupancies have not yet hit their low point, and the remaining 19% were uncertain. Even though there is this divide on whether we have hit bottom or not, the reason why that didnt translate to a more negative overall sentiment is because the economy has held up and net absorption was positive in the third quarter across all property types, adds Nadji. [Figure 2]. Apartments continue to distance themselves from the rest of the commercial real estate pack. Although investor sentiment

Fourth Quarter 2011 Real Estate Investment Outlook

Fourth Quarter 2011 Real Estate Investment Outlook

FIguRE 3. InvEsTOR PERcEPTIOn OF PROPERTy TyPEs

In your view, is now the time to buy, hold or sell each of the following property types? Percentages reflect only the opinions of respondents invested in each property type. Apartment Hotel 5% Industrial
7% 15% 21% 44% 49% 51% 13% 10% 49% 44% 53%
20% Hold Buy 40% 60% 80%

63% 49% 43% 42% 37% 43% 39%

100%

Mixed-use 4% Office Retail Undeveloped Land 5%

0% Sell

Base: respondents to the 4Q 2011 study (591).

for this property type did drop a slight three points from the second quarter, apartments still post the strongest showing with an index level of 163, well ahead of hotels at 144, mixed-use at 126, industrial at 125, retail at 119 and office at 110. Apartments have benefited from drivers that are unique to the sector, including a decline in homeownership and strong renter demographics. The net absorption of apartments during the third quarter totaled 37,223 units, which helped to drop vacancies to 5.6% a 1.5% improvement compared to third quarter 2010. During the same period, year-over-year effective rents rose 2.4% to an average of $975, according to Marcus & Millichap. Overall, 63% of apartment investors believe now is the time to buy more [Figure 3]. An even larger percentage, 68%, expect apartment values to increase over the next 12 months.

Is the bottom in sight?

Investors are less bullish on other property types, and opinions vary on the outlook for the retail, hotel, office and industrial sectors in the coming year. Retail sentiment fell sharply compared to second quarter. That drop in sentiment is not a surprise, because at the peak of the August-October economic concerns, fears of a recession would have meant another consumer pull back, says Bill Rose, national director of Marcus & Millichaps National Retail Group. The good news is that retail sales remained positive, and did not confirm those fears. Among respondents who own retail properties, 32% expect property values to increase in the coming year, compared to the 44% who held the same view in second quarter. More than half of investors, 52%, expect values to remain the same, 14% anticipate a decline in values and 2% have no answer.

Concern for retail investments persists because retail spending is highly bifurcated, adds Rose. High net-worth households are spending much more robustly, which has buoyed luxury and high-end retailers. At the opposite end of the spectrum, discount retailers have benefited from the frugality that has set in for many consumers, continues Rose. Those retailers in the middle face more challenges and uncertainty. It is a very fragmented recovery when it comes to retail real estate, concludes Rose. In addition, the performance of retail centers varies widely by market and depends upon a propertys position within that market. Overall, U.S. retail vacancies have improved a slight 20 basis points over the past year to reach 10% as of the third quarter. At the same time, effective rents have slipped a further -0.2% to average $15.91 per square foot, according to Marcus & Millichap. Industrial and office owners are slightly more pessimistic in their views of these property types compared to the second quarter survey. More than half of industrial owners, 56%, expect industrial values to remain the same over the next 12 months, with 34% anticipating an increase and 9% predicting a further decline. That response is more positive compared to a year ago when 29% of respondents expected values to rise. However, it is not as strong as the second quarter where nearly half of respondents, 48%, predicted an increase in industrial values. Office owners also showed a slight decline in confidence on property values with 28% of respondents predicting an increase in the coming year. That response matches the response in the fourth quar-

Fourth Quarter 2011 Real Estate Investment Outlook

Fourth Quarter 2011 Real Estate Investment Outlook

One of the drivers of increased capital flows into commercial real estate this year is that you can lock in incredibly low interest rates ahead of eventual rent growth, says Nadji.
ter 2010 survey, but shows a dip in confidence compared to the 36% of respondents in the second quarter 2011 survey who thought that office values would rise over the subsequent 12 months. The uncertainty over the last three months had a negative impact on absorption for both office and industrial. Even though leasing activity is still positive, the pace of leasing slowed down as companies became hesitant, says Al Pontius, managing director of Marcus & Millichaps National Office and Industrial Properties Group. Industrial vacancies dropped 70 basis points over the past year to reach 12.1% as of the third quarter, while office vacancies improved a slight 20 basis points to 17.4%. The good news is that net absorption of space has remained positive but disappointingly slow. It will be interesting to see what happens in the fourth quarter if we get a little more confidence back, especially as the stock market appears to be recovering. We might pick up the pace of recovery, Pontius adds. Although investor sentiment for hotels did slip in fourth quarter, hotel owners remain optimistic in the outlook for this sector overall. Nearly half of respondents, 49%, believe that now is the time to buy more hotels, compared to 68% of respondents in the second quarter survey who thought it was a favorable time to buy. In year-over-year comparisons for the week of October 16, occupancy rose 4.0 percent to 66.2 percent, the average daily rate increased 4.4 percent to $105.49, and revenue per available room finished the week up 8.6 percent to $69.88, according to data from STR Global in Hendersonville, Tenn. More than half of respondents who own hotels, 54%, expect their property values to rise further over the next year, while 35% expect no change and 10% predict a decline. The average change in value expected is 5.7%. Hotels correlate with economic activity very highly, says Nadji. So part of the reason there is optimism on the hotel side is that the economic wheels are not coming off again. ic recovery and disrupt capital markets. Recent hiccups in the CMBS market and the withdrawal of the Goldman/Citi offering is one issue on the watch list. I think the CMBS market is going to be a bumpy ride the next couple of years, writes one respondent. The vast majority of respondents, 87%, cite the state of the U.S. economy as their top concern in the coming 12 months. Most respondents also are wary of top issues such as high unemployment (and underemployment): 68%; political uncertainty: 54%; large federal and state budget deficits: 53%; and availability of financing: also 53%. Despite the numerous hurdles that remain in the path of recovery, the bottom line is that the U.S. economy is forging ahead. In addition, the news coming out of Europe since the end of October is encouraging and is pointing toward a systematic solution to the European debt crisis. It is still too soon to say that we are out of the woods, notes Nadji. But a resolution to the debt crisis would certainly help to remove a large cloud that has been hanging over the global recovery. Even modest levels of growth will be enough to continue the improvement in occupancies across all property types but were still in for a slow recovery. We added 1.8 million private sector jobs in the past year, he adds. That is the key reason occupancies have stabilized and are begining to improve. n

Optimism prevails
The fact that investors are not panicking in the face of political and economic uncertainty is a positive sign for continued recovery in the commercial real estate market. That sustained confidence also reinforces investor opinion that commercial real estate remains a favorable investment alternative. The majority of respondents, 60%, plan to increase their commercial real estate investment over the next 12 months, while 22% expect investments to remain the same, 6% anticipate no change and 2% did not respond. Among those who do plan to grow their real estate holdings, an average increase of 23% is predicted. That optimism is tempered by a healthy dose of caution. Respondents are clearly worried about potential obstacles that could rise up and derail the econom-

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