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Insights Trends - Owners - Transwestern

INSIGHTS + TRENDS + OPPORTUNITIES

TRANSWESTERN

2Q 2010


INSIGHTS + TRENDS + OPPORTUNITIES

TRANSWESTERN

2Q 2010

Transwestern is one of the largest privately-held commercial real estate firms

in the United States. A diversified operating company, Transwestern is active

in the real estate service, development and investment management businesses.

Transwestern creates value for clients through innovation, penetrating market

intelligence and legendary service delivered by teams of local market experts.

The firm has product specialties including office, industrial, retail, multifamily

and healthcare, as well as a wholly-owned research affiliate, Delta Associates.

Transwestern leads the industry in sustainability and has received multiple

ENERGY STAR® awards from the Environmental Protection Agency (EPA).

© 2010 TRANSWESTERN

www.transwestern.net

For more information and research, visit www.transwestern.net/research

In this edition:

A Message from Larry Heard:

Welcome to Insights, Trends &

Opportunities

Delta Associates:

Economic Outlook:

Our Thoughts on Interest Rates

Delta Associates:

Commercial Real Estate Outlook:

Have Values Stabilized?

From the Field: Industrial Outlook

Long-term prospects will prove

positive

By Caulley Deringer

Senior Vice President,

Commercial Leasing

JOIN THE CONVERSATION

Twitter: @TRANSWESTERN

LinkedIn: companies/transwestern

YouTube: TRANSWESTERNTV


TRANSWESTERN

A Message from Larry Heard

Welcome to Insights, Trends & Opportunities

By Larry P. Heard

President & Chief Executive Officer

Welcome to Transwestern’s newest

client communication – Insights, Trends

& Opportunities. We have developed

our content in this new publication in

response to the survey many of you

recently completed. We trust our latest

offering provides the penetrating insight

and take-home value you have come to

enjoy. Our focus in Insights, Trends &

Opportunities will be on trends affecting

the CRE industry, economic analysis,

government policy and its impact on

CRE as well as subject matter experts

discussing relevant current events in our

business.

The stops and starts associated with the

current “recovery” have many perplexed

and experts lined-up on each side of the

“double dip” question. My perspective

is that we will avoid a double dip but no

one should plan for a robust recovery any

time soon. The underlying fundamentals

in most businesses remain relatively

stable but when coupled with anemic

job growth, not much good can emerge

in the near term to positively affect our

industry. Additionally, most banks still

have substantial flexibility in dealing with

their troubled loans which adds to my view

that we will experience a more protracted

and elongated recovery period.

Now is the time for firms to do what

they do best and remain focused on

adding value. It is also a time to look

opportunistically to the future and

explore strategic expansion initiatives.

We at Transwestern are intent on excelling

in both areas and doing so to the benefit

of our clients. We appreciate the business

you have entrusted to Transwestern, and

we look eagerly forward to dealing proactively

with our ever changing economic

landscape.

All the best,

“Now is the time

for firms to do what

they do best and

remain focused on

adding value.”

2Q 2010 INSIGHTS TRENDS OPPORTUNITIES


DELTA ASSOCIATES

Economic Outlook:

Our Thoughts on Interest Rates

By Delta Associates

A critical ingredient for enlivening the commercial real estate

market is the availability of credit at terms that are attractive

to borrowers. Interest rates have been low, but credit has been

hard to come by due to the persistent turmoil in the financial

markets and the lingering effects of the recession. If mortgage

interest rates remain low, they can facilitate a recovery in the

economy as well as the commercial real estate market. What

is likely to happen in the credit markets during the balance of

2010 and beyond?

Long-term mortgage rates are likely to rise due to government

deficit spending, as the Federal government will have to offer

higher interest rates to continue to attract capital. As shown

in the accompanying graphs, the U.S. Treasury issuance is

increasing dramatically during the 2009-2011 period, relative

to the long-term average, to accommodate the deficit spending

that was designed to avoid a depression and spur an economic

recovery. The good news: we avoided a depression. The bad

news: rising interest rates could hinder the pace of recovery in

both the economy and the commercial real estate market.

At the same time, some buyers of debt, such as China, are easing

back on their purchases of American Treasury bills for both

financial and political reasons, which will drive the Federal

government to increase interest rates in order to make U.S.

debt more attractive to buyers. As interest rates for Treasuries

rise, interest rates on all forms of long-term debt, including

commercial mortgages, will follow suit.

We believe that the availability of credit will increase during

2010, but that interest rates will increase 50 to 250 basis points

in 2011 and 2012. While availability of credit likely will remain

a problem throughout 2010, despite some improvement, real

estate investors who have access to credit should be prepared to

act quickly this year before rates become less attractive. One risk

to this prognostication is the debt crisis in Europe. If the bailout

efforts prove ineffective, the recent Wall Street correction could

develop into a full-fledged bear market. That would reallocate

funds from securities to bonds, driving down yields. But such

a move would be temporary, in our judgment – putting off the

inevitable rise in long-term rates.

With an increase in mortgage interest rates, we expect three

significant effects for the commercial real estate market:

1. Cap rates that began to settle down – in fact, drift lower

in some markets for Class “A” assets – at the end of 2009

likely will not decline much in 2010-2011 even if good

product is in short supply. However, even a slight decline

in cap rates would be a welcome change from what we

experienced in 2008-2009.

2. Cash will remain king through at least 2011.

3. It is probable that development lending will remain lean

over the next 12-24 months, leading to a “hole in the

market” for deliveries of new product. This in turn will

create rent spikes in 2013-2015 in many metro markets.

+ Want to know more about what Delta produces nationally? www.DeltaAssociates.com


Delta Associates

Long-term mortgage rates are likely to rise due to government

deficit spending, as the Federal government will have to offer

higher interest rates to continue to attract capital.

Federal Budget Deficit

1991 – 2015

U.S. Treasury Issuance

FY 1996 – 2011

$300

$2,500

$0

$2,000

Billions of $

-$300

-$600

-$900

Gross Treasury Issuance (in Billions)

$1,500

$1,000

$500

-$1,200

0

‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11

-$1,500

‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10*‘11*‘12*‘13*‘14*‘15*

Source: OMB, CBO; July 2010.

*Baseline projection by CBO as of March 2010.

Source: U.S. Treasury, Morgan Stanley, SIFMA, Delta Associates; July 2010.

Note: Interest-bearing, marketable coupon public debt; 2010-2011 is

estimated/projected.

2Q 2010 INSIGHTS TRENDS OPPORTUNITIES


DELTA ASSOCIATES

Commercial Real Estate Outlook:

Have Values Stabilized?

By Delta Associates

Are we there yet? After a 30 percent to 40 percent decline from

the peak in late 2007, has the decline in commercial property

values stopped? Value declines have been even more severe for

Class “B” product and in secondary markets or deals with hair on

them. However, as shown in the accompanying graph of NCREIF

capital returns (which encompass mostly core assets in primary

markets), the decline in value slowed throughout 2009; by the 1st

quarter of 2010, values had nearly stabilized.

It appears that values have hit the cyclical bottom quickly during

this cycle, compared with the early 1990s, declining almost the

same percentage in two years (2008-2009) as they did in six years

during the 1990-1995 period. The 2008-2009 rapid decline was

triggered in part by an extreme lack of liquidity, but was probably

due more to improved market intelligence and a heavy dose of

fear.

Why the quicker plateau in values this time?

•In contrast to 1990, institutions have not reallocated their

assets away from commercial real estate.

•The equity REITs bounced back early – and they did not

exist in real numbers in the early 1990s. They have been

active, early buyers.

•Regulators are taking an accommodative stance this time

in contrast to the RTC days – and this has kept a flood

of properties off the market which in the 1990s depressed

pricing for years.

We expect these trends – stable cap rates and values and an uptick

in transaction volume – to continue during 2010 and 2011, as

the employment picture gradually brightens, generating new

demand for office and industrial space and apartment units. The

improvement will be slow, however – particularly for the office

sector – as shadow space (leased but underutilized space) will act

as a drag on new leases. Values will improve as a result of market

fundamentals, rather than cap rate compression.

When will we return to the peak values of the 2005-2007 period?

For the answer to this question, please see the next issue of

Insights, Trends & Opportunities.

•There appears to be trillions of dollars of equity on the

sidelines – and it is beginning to buy early in this cycle, as

evidenced by an upturn in transaction volume since the

fall of 2009 (shown in the adjacent graph).

+ For more information and research, visit www.transwestern.net/research


Delta Associates

We expect these trends – stable cap rates and values and an

uptick in transaction volume – to continue during 2010 and 2011,

as the employment picture gradually brightens, generating new

demand for office and industrial space and apartment units.

U.S. Commercial Real Estate Values

1989 – 1st Quarter 2010

U.S. Property Sales

2008 – 1st Half 2010

$35

15%

$30

10%

5%

$25

- Office

- Apartments

Annual Change in Value

0%

-5%

-10%

Property Sales (in Billions)

$20

$15

$10

-15%

$5

-20%

-25%

‘89 ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10

$0

1st

Half

2nd

Half

1st

Half

2nd

Half

1st

Half

2008 2009 2010

Source: NCREIF, Delta Associates; July 2010.

Source: Real Capital Analytics, graphic by Delta Associates;

July 2010.

2Q 2010 INSIGHTS TRENDS OPPORTUNITIES


TRANSWESTERN

From the Field: Industrial Outlook

Long-term prospects will prove positive

By Caulley Deringer

Senior Vice President,

Commercial Leasing

The U.S. economy is showing increasingly

positive signs that recovery is underway,

and according to most economists the

recession is behind us. However, the

commercial real estate market is in

for a potentially tumultuous year as

underperforming assets will be the focus

of lenders, and the sale of distressed

properties will increase. For those us that

primarily deal in industrial, we expect

our sector to trail the economic recovery.

However, we will see benefits from

economic expansion as retailers increase

stock inventory to fulfill increasing

demand for goods both domestically and

abroad. 2010 and well into 2011 will be

the recovery period, but will remain very

much a tenant’s market as many areas of

the country will experience another year

of net negative absorption resulting in

lower rental rates and increased landlord

concessions. Though fewer than in

2009, continued corporate downsizings

and consolidations will have a negative

effect on the absorption of space while

increasing the percentage of sublease

space. The industrial sector will likely

recovery sooner than the office sector

as the increase in retail sales volume will

“Landlords who

focus on first-class

service and renew

their tenants early

with aggressive

lease terms will

enjoy greater

retention.”

create an immediate demand for retailers

to stock warehouses and reinvigorate

their distribution channels. Additionally,

the manufacturing sector continues to

improve which will also have a positive

bearing on the need for industrial space.

Landlords who focus on first-class

service and renew their tenants early

with aggressive lease terms will enjoy

greater retention. Alternative leasing

opportunities are very high, and the

incentives hungry owners are willing

to offer make it very easy for business

owners to consider relocation. For many

user groups, finding the most functional,

least expensive space is the primary

goal. Expect well-established businesses

to take advantage of a strong tenant

market and lock into long-term deals.

Business owners with less certainty will

focus on short-term renewals rather than

endure the expense and inconvenience of

relocation.

Well funded investors with the ability to

do low LTV deals will be positioned well

for investment opportunities in 2010

and 2011. Most of 2009 and the first half

of this year have offered few purchase

opportunities as most sellers are still

discouraged by pricing, especially in

comparison to what properties were

worth just two years ago. However,

sellers of institutional quality assets may

be in for a surprise as REITs and other

cash-rich buyers are anxiously awaiting

assets to acquire. The demands they have

to place money this year are considerable.

This will create a competitive

environment that will boost prices on

high-quality industrial and flex assets

in popular markets. Since rental rates

have diminished considerably during the

downturn, buyers will focus less on cap

rates and more on cash-on-cash returns

to determine an asset’s value.

+ Want to know more about industrial real estate?

caulley.deringer@transwestern.net

703.749.9415


Industrial

As an example, the Washington, D.C. industrial market was certainly impacted, but less so than most other markets around the

country, as a result of its proximity to the Federal government. The stimulus package benefited many local companies allowing

most submarkets in the Maryland and Virginia suburbs to ride out the storm. Vacancy rates are low in comparison to the rest

of the nation at 10.9 percent in Virginia and 11.6 percent in Maryland, with several submarkets already showing strong signs

that positive net absorption is a legitimate possibility for year-end 2010. Rental rates have stabilized as have concession offerings

and the absorption of a good portion of the recently constructed inventory indicates 2011 will be the transition year, as new

development is anticipated to commence in stronger submarkets in the next 18 to 24 months.

As economic recovery continues, the long-term prospects for the industrial sector are positive and new development in stronger

submarkets will likely start in 2012. The construction period for industrial product is considerably less than office, allowing

developers a better opportunity to “time” a market. Expect developers in stronger markets, where the residential market is in

full recovery, to take advantage of an earlier economic growth resulting in an increase in storage/distribution needs. 2010 will

also provide investors greater buying opportunities to purchase properties at levels not seen in years. All-cash buyers will be able

to take advantage of below replacement cost opportunities, but will see a high level of competition for good product in stronger

submarkets.

Caulley Deringer specializes in the leasing and sale of flex and industrial properties in the Northern Virginia market. He also serves

as a member of Transwestern’s Board of Directors and was the firm’s top producer in 2009.

U.S. Flex/Industrial Vacancy Rates

2008 - 1st Quarter 2010

U.S. Flex/Industrial Average Asking Rents

2008 - 1st Quarter 2010

(triple net, per SF per year)

12%

$8

10%

$7

Flex/Industrial Vacancy Rates

8%

6%

4%

Average Flex/Industrial Asking Rents

$6

$5

$4

$3

$2

2%

$1

0%

Q1

‘08

Q2

‘08

Q3

‘08

Q4

‘08

Q1

‘09

Q2

‘09

Q3

‘09

Q4

‘09

Q1

‘10

$0

Q1

‘08

Q2

‘08

Q3

‘08

Q4

‘08

Q1

‘09

Q2

‘09

Q3

‘09

Q4

‘09

Q1

‘10

Source: CoStar, Delta Associates; July 2010

Note: Vacancy rates include sublet space.

Source: CoStar, Delta Associates; July 2010

Note: Includes all types of flex/industrial product.

2Q 2010 INSIGHTS TRENDS OPPORTUNITIES


INSIGHTS + TRENDS + OPPORTUNITIES

TRANSWESTERN

www.transwestern.net

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Twitter: @TRANSWESTERN

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