Recovery from the Great Recession promises to be muted and choppy, a departure from previous signifi cant contractions, most of which were followed by above-average growth.

The second half of this year will mark an important turning point for the U.S. economy, as the business sector will need to replace government stimulus as the primary driver of overall growth. After a prolonged period of cost-cutting and conservation, a corporate-led expansion has become essential to the onset of a self-perpetuating growth cycle, since consumers remain cornered by high unemployment, tight credit conditions and steep housing-related losses to net worth.

Economic Recovery Gaining Traction; Increased Business Activity Needed for Expansion to Become Self-Sustaining

The economic recovery continues to make headway, with GDP posting its third consecutive increase during the first quarter. Although the headline rate of growth reflects a deceleration from late 2009, underlying shifts among the contributing components provide cause for optimism. To start, business spending continued to rise, with investments in equipment and software registering a third consecutive increase for the first time since before the recession began, suggesting the transition bfrom a stimulus-driven recovery to a sustainable business expansion cycle is already under way.

AFTER A QUIET YEAR OF INVESTMENT SALES, BUYERS ARE PREPARING TO FORGE AHEAD WITH ACQUISITIONS IN 2010.

Two-thirds of investors (65%) who responded to the 6th Annual Investment Survey plan to boost their investment in commercial real estate over the next 12 months. That fi gure is up from 56% in the third quarter and 51% a year ago. The exclusive survey is produced jointly by National Real Estate Investor and
Marcus & Millichap.

The fact that buyers are once again returning to the table is a huge vote of confidence for a commercial real estate industry that has been slammed in the past year by falling property values, occupancies and rents. Respondents to the annual survey who do plan to expand existing portfolios anticipate an average increase of 26%, up from 24% in the third quarter and 22% a year earlier.

MEDICAL OFFICE SECTOR AVOIDING ILLS OF TRADITIONAL OFFICE MARKET

With healthcare remaining the strongest sector of the economy, adding 222,000 workers so far this year for growth of 1.4 percent, medical offi ce building (MOB) assets have been much more stable than traditional offi ce properties.

Only 1 percent of MOBs are currently distressed, equating to just $200 million in troubled loans, compared with almost $20 billion for the 3 percent of traditional offi ce assets now at risk. While its performance is clearly stronger than other property sectors, the MOB segment remains under pressure. Recessionary stresses and rising medical costs have kept a portion of the U.S. population on the sidelines for elective outpatient care, easing demand for physicians’ services and, in turn, medical space. As a result, deliveries have recently outpaced absorption and vacancy has ticked up, forcing operators to lower rents in an effort to keep occupancy levels in check.

Concerns earlier in the year about the effects of new supply on near-term office property performance measures in Miami-Dade County have eased, supplanted by the realization that job losses continue to weaken space demand. Projected completions for 2009 have been scaled back, as two developments totaling more than 1.1 million square feet have been delayed until 2010, presumably as a result of tepid pre-leasing.

With the delays, next year’s deliveries are on track to exceed 1.9 million square feet. As construction has lagged this year, local offi ce-using employers have trimmed approximately 4,200 positions , resulting in negative net absorption of 966,000 square feet and a surge in concessions. If there is a bright spot in current employment trends, it is that the pace of office-using job cuts decreased in the past two quarters. Any additional gains or an easing in layoffs could stem the erosion of property fundamentals. Still, vacancy is expected to rise further in the coming months , ending the year at more than 15 percent, while asking rents will slide to a level last recorded about two years ago.

Several indicators offer cause for guarded optimism, though the economy has not yet cleared the woods. While U.S. GDP contracted for the fourth consecutive period in the second quarter, the rate of decline slowed dramatically. Government spending and net exports posted moderate growth during the quarter; however, personal consumption, which accounts for 70 percent of GDP, weakened further. Employment trends continue to reflect softening across industries, though job losses have decelerated.

Until meaningful and sustainable job growth resumes, which is unlikely until at least mid-2010,
consumers will remain cautious. Since the U.S. economy is largely consumer-driven, this greatly reduces the chances of a snapback recovery, which has followed some recessions. Instead, the economy will likely stabilize and post only modest expansion starting in late 2009. The outlook for even mild GDP growth is based on assumptions that housing has touched bottom and the stimulus package has started contributing to growth.

Having weathered the recession with resilience throughout most of 2008, commercial real estate is now facing a dual challenge of rising vacancies and exceptionally tight debt financing. Both are largely the result of the escalation of the recession into a global financial crisis last fall.

Tangible results from government initiatives to stimulate the economy and loosen lending are modest at best; however, it is clear that government action helped to avert the worst-case scenario. Interbank lending has stabilized; investor and consumer confidence levels have moved off of recent lows; home sales are rising, albeit largely as a result of foreclosures; and aggressive cost-cutting is resulting in better-than-expected corporate profits. The U.S. economy and the availability of debt capital have a long way to go before returning to “normal,” and many challenges remain. It appears, though, that conditions are improving and moving in the right direction.

Bill Hughes discusses with Alex Zylberglait on a public conference call, the current state of capital markets. The discussion focused on:

• Current state of credit markets
• What has happened to government bailouts - TALF?
• What financing is getting done today?
• Will CMBS ever return as a viable source of debt?
• Term maturities and how lenders are dealing with them. Where are rates headed?
• Is there relief in sight?

Bill Hughes, Senior Vice President and Managing Director of Marcus & Millichap Capital Corporation.

Bill is responsible for MMCC's daily operations. Mr. Hughes has a diversified background in real estate finance, financial consulting and modeling, project feasibility, leasing, construction management and real estate development. He joined Marcus & Millichap in 1996. Previously, as a senior executive with Lomas & Nettleton Real Estate Investment Banking, principal partner with Mason McDuffie Financial Corp. and a principal partner with Fountainhead Enterprises, Mr. Hughes participated in the development, finance and sale or leasing of more than $2 billion worth of commercial property. Mr. Hughes is a graduate of the University of Southern California. While at USC, his emphasis was in both finance and accounting.

Property fundamentals are softening considerably in the Miami-Dade County office market, as a significant amount of new product is being delivered at a time when job reductions are eroding space demand. Completions in the past year have expanded the stock of for-lease properties 1.8 percent, while approximately 16,000 office-using positions have been cut, a 6.6 percent drop. Additionally, if the projects currently under way and slated for delivery in 2009 are completed as scheduled, for-lease stock in the county will increase by the greatest amount in any single year since the late 1980s.

Meanwhile, job losses will continue as the county proceeds through the worst stretch of the current recession. Employment cuts through the remainder of the year will lead to negative net absorption of approximately 1 million square feet, while rents will come under pressure as property owners compete rigorously for a diminished pool of prospective tenants. Sublease space has increased recently and will also pose a source of competition for owners seeking to replace tenants.

Medical Office Sector Remains Healthy in Ailing Economy

Unlike other asset types, medical office properties continue to garner investor demand by exhibiting considerable resistance to the economic downturn.

Nonetheless, there are locales across the country where medical office assets are underperforming, and in many instances, there is upward pressure on vacancy.

The segment, however, is holding up better than other product types. Much of the economic resilience tempting investors can be attributed to the positive state of the health care industry. The nation spends over $2 trillion on health care annually, more than double U.S. expenditures on food, and health care spending is projected to exceed $3 trillion by 2013.

National Office Market Overview

Unlike past cycles, overbuilding is not the major cause of the current downturn. Office deliveries are forecast to total
51 million square feet in 2009, following the completion of 58 million square feet last year, nearly 70 percent lower than
construction levels in 2000 and 2001, prior to the last downturn. Deliveries are expected to fall off considerably next
year, paving the way for a demand-based recovery in 2011.

As employers continue to trim payrolls, demand for office space will wane. The national office vacancy rate is forecast
to increase 310 basis points this year to 17.6 percent.

Rents at the national level turned negative in the second half of last year, and further downward pressure is expected
going forward. In 2009, asking rents are forecast to drop 7.6 percent while effective rents decline 9.4 percent.

A Winning Prognosis for Medical Office Investments

Healthcare reform has emerged as a top priority for the new administration, and opportunities within medical office investments bear close monitoring as a result. At present, rising medical costs, a lack of access and quality concerns are preventing many Americans from seeking regular care. Compounding these problems are economic uncertainty, extreme job losses and corporate benefit cuts. In spite of the issues, the medical office sector is outperforming traditional office properties, and demand should increase considerably as a growing share of the population is covered by health insurance.

Government Intervention, Bank Stress Tests Aim to
Restore Confidence — Will Measures be Enough?

Government stimulus and financial market intervention — already at unprecedented levels — have become even more aggressive in the wake of a steeper recession and escalating credit market woes. Government loan facilities established last year are being modified, and new programs have been proposed to help jumpstart stalled credit markets.

The first round of funding for the Troubled Assets Relief Program (TARP) was originally intended to buy toxic assets from financial institutions, but the capital was instead used primarily to purchase equity shares of major banks. Therefore,
toxic assets, which include difficult-to-price mortgage-backed securities, have remained on the balance sheets of financial institutions. Uncertainty and the potential for significant write-offs associated with these assets have subsequently hindered
banks’ ability and willingness to originate new loans.

With toxic assets still a crucial hurdle to be cleared before the financial system can function effectively, the government has become more focused on the issue. In addition to the stimulus
package, new programs aimed at restarting the market for these assets have been proposed. While these measures are expected to positively impact capital markets, it likely will require at least six months for credit flows to improve measurably.

Capital Markets Developments since December 2008

The Good News:

1. Inter-bank lending continues to improve

2. LIBOR and TED spreads have stabilized

3. 10-Year Treasury Yield at 2.76% remains at a very low level

4. Delinquencies continue to be near historic lows but are rising

5. Deals are getting done –local and regional banks, life insurance companies

Despite declining construction, office vacancy is forecast to rise to the 17 percent range in 2009.

On a positive note, the combination of reduced supply and the fact that most companies did not lease significant excess space during the most recent expansion should prevent a prolonged downturn, with the onset of a recovery likely in 2010.

Economic Data Offers Cause for Cautious Optimism: Home Sales Rise, While Job Losses Down from Peak

Recession Drivers Shift. U.S. GDP contracted at an annualized rate of 5.7 percent in the first quarter of 2009, following a 6.3 percent decline in the previous quarter. Despite dramatic decreases in both quarters, the components of change varied significantly. Weakness during the fourth quarter was driven by a pullback in consumer spending, while contraction in the first quarter was due largely to drastic cutbacks in business spending and inventory reductions. During the first quarter, consumer expenditures made a positive contribution to GDP for the first time since mid-2008, and consumer confidence began to improve. Retail sales slipped in March and April before rising minimally in May, however, as consumers remained cautious, driving the savings rate to its highest level since 1995.

 

Although recent positive trends have provided reason for guarded optimism and consumer confidence has improved, the recession persists and is likely to result in additional employment cuts and a decline in GDP this year.

Weak consumer spending, driven by job losses, a soft housing market and the propensity of Americans to save more,
will continue to suppress demand for foreign-made goods and reduce space demand from import-related businesses.

In the first quarter of 2009, GDP decreased at an annualized rate of 5.7 percent. The U.S. economy is forecast to shrink 2.9 percent this year, compared to a 1.1 percent annualized increase in 2008. In addition to the decline in U.S. GDP, a
slump in foreign economies will reduce demand for U.S. goods abroad and adversely affect warehouse space demand among export-related businesses.