Special Report: Financial Market Crisis and Commercial Real Estate

Special Report Executive Summary

The initial failure of the Emergency Economic Stabilization Act (EESA) in the House of Representatives exacerbated already tight credit conditions. Of particular importance are the interbank lending logjam and the nearly frozen commercial paper market, which is widely used by companies to fund daily operations. Given the severity of these credit market issues, the Senate and the House acted quickly to pass a revised version of the bill.

The passage of the rescue package, which includes the Troubled Asset Relief Program (TARP), did not immediately boost confidence but should at least help to normalize credit markets in the coming weeks. Otherwise, Fed intervention directed at interbank lending and the commercial paper market may be necessary. The bill is unlikely to deliver a quick overall fix due to the complexity and magnitude of financial issues.

EESA/TARP Summary: Pages 3 & 4

• A widespread financial crisis has evolved as the domino effect of plunging stock prices and the liquidity crunch have led to mergers, bankruptcies and government intervention.


• Rapid de-leveraging of financial markets and unwinding of troubled assets resulted in a plan aimed at addressing illiquid assets clogging the financial system instead of further one-off bailouts. Under the EESA, the TARP will make up to $700 billion available to the Treasury to purchase illiquid assets from institutions, with the intent of unlocking credit markets.


• Due to the complexity of financial instruments and the interconnectedness of the financial sector globally, the magnitude of potential risk and the sufficiency of the rescue package remain difficult to quantify.

Economy and Financial Markets: Pages 5 & 6

• Companies were relatively lean heading into the current downturn and job losses were below-trend until recently, when contraction within the manufacturing and financial sectors worsened.


• The September jobs report confirmed an acceleration in job losses to 159,000 positions, up from the eight-month average of 75,000.


• Wall Street woes have exacerbated the credit crunch, further limiting the availability of credit to businesses and consumers, which in turn will hinder spending and intensify the downturn.


• Exports, which have been a major offset to housing, will slow as the global economy downshifts.


• Economic stimulus checks are largely spent, removing a key element for second half GDP.


• Oil prices are well below their peak, relieving some inflationary pressure; however, further volatility is likely.


• The key factor influencing the direction of the economy is how long it will take for credit markets to normalize. The current situation has intensified the strain above and beyond a cyclical downturn.

Commercial Real Estate Financing: Page 7

• Capital remains constrained, with borrower requirements and underwriting adjusting to increased risk in the marketplace. Assumable loans, still-active portfolio lenders and agency funding are supporting property sales, mostly in the small to mid-size range.


• LIBOR-based loans, mainly utilized on construction projects and some short-term bridge situations, have become problematic for some developers and increase the risk of more foreclosures.


• Debt-service coverage ratios have increased to 1.25x to 1.30x and downpayment requirements now average 30 percent to 45 percent.


• Tighter underwriting will prevail over the foreseeable future and spreads will remain volatile.

Impact on Commercial Real Estate Investment Market: Pages 8 & 9

• In the short term, further economic weakness will be reflected in higher vacancies; however, limited construction during the past cycle should keep vacancy rates below prior-peak levels, with the exception of retail. A prolonged credit downturn is the greatest risk to the forecast.


• The credit crunch is hindering transaction velocity and will further pressure prices in the short term; however, it is also resulting in a significant dropoff in construction starts.


• Apartments continue to report the healthiest fundamentals, followed by warehouses. The office and retail sectors will show further weakness in the months ahead.


• High-profile defaults, mostly high-leverage deals closed at the market's peak, failed conversions and speculative development, are significantly more challenged than the overall marketplace.


• Commercial mortgage delinquency rates will rise from current lows but are not expected to reach prior peak-levels in most property types.


• Recent financial market turmoil will further fuel the "flight to safety" among commercial real estate investors and lenders. Top-tier properties in primary markets will remain the least vulnerable to price correction.

Recent Events Summary: Pages 10 & 11

• Starting with the failure of Lehman Brothers and sale of Merrill Lynch, the global financial market turmoil of the past year rapidly escalated to a full-blown crisis. Events in recent weeks range from bank seizures, buyouts and mergers to the end of the traditional Wall Street investment banking industry.

U.S. Financial Crisis - How Did We Get Here?: Page 12

• While the financial sector deteriorated rapidly in recent weeks, troubles have been building for some time. Given the unique and complex nature of the current financial crisis, many investors may be asking how we ended up in this situation.

Sam Zell was on CNBC today commenting on the commercial real estate market (among other things). I think you will find his comments interesting and I recommend watching the video clip. I have highlighted some of the relevant comments below, which come from an interview with Maria Bartiromo while Zell was at the DLA Piper Real Estate Conference. For your information, I recommend downloading the DLA Piper State of the Market Survey as well.

Also, please remember to check our Market Trends (Office Market Trends Industrial Market Trends) reports, which we publish for major MSAs throughout the US. The 3rd Quarter reports were recently updated.

Here are the highlights of Sam Zell's interview:

"I believe that the commercial side of the business, although I expect it to get weaker because the economy is weaker, but without new supply, it's very hard to see the kinds of commercial disasters that we've had at, say, the beggining of the 90s."

"The headlines of the [DLA Piper] conference are extraordinarily bearish. Interestingly enough, the last conference was 18-mos ago and they were extraordinarily bullish at the time. So, I would suggest to you that if you bet against conventional wisdom, you do terrific. And it seems to me that I would bet against both the tenor and the sense of gloom that exists not only at that conference, but across the country. When it's all said and done, the commercial real estate industry has for all practical purposes, stopped creating new product and banks have stopped creating construction loans. And ultimately, that's going translate into benefits for those that own well-located brick and mortar."

On the bailout of Bear Stearns, Fannie/Freddie, AIG:

"Clearly that doesn't fit my definition of a free market system. On the other hand, the reason free markets have survived is our ability to periodically change the rules to overcome a problem. Much of the problem we have today, in my opinion, really goes back to the post dot-com boom where we created free money. And, human nature is human nature, and it attracted everybody. And despite what you see in the newspapers and in the political campaign, the vast majority of what I would call the defaulted mortgages probably never should have been made in the first place and the borrowers shouldn't have borrowed and the lenders shouldn't have lent. We need to fix that and the scale of the problem is such that it's bigger than any individual or group of individuals can handle."

Mohamed Ali Alabbar, Chairman of Emaar (one of the largest real estate companies in the world) spoke with CNBC's Erin Burnett today and had the following to say regarding the US Real Estate market:

"Everyone has their money in the USA. It has changed my psychology. Let's be honest, it affects all of us. We're putting in more controls because when you see your neighbor crying, you don't want to be there."

"I still see opportunities. We are beginning to see opportunities in the States now. We are looking at buying real estate. Not companies, because you can't know what you are buying right now. But straight real estate."

- Mohamed Ali Alabbar, Emaar Chairman

Keep in mind we recently posted our 3rd Quarter Office Trends and Industrial Trends reports. These will help the international investor truly understand the local markets and which direction trends are headed.

Click here to watch Harvey Green, Marcus & Millichap's CEO, on CNBC recently.

MEDICAL OFFICE ASSETS RESISTANT TO AILING ECONOMY

(Note: PDF of this report is available here)

Demand for medical office space continues to be driven by several factors, including the migration of more procedures from hospitals to an outpatient setting, the expansion of existing practices and the increasing obsolescence of aging assets. Additionally, the growing trend of hospitals expanding to offer medical services at off-campus satellite facilities is expected to accelerate in the future as medical practitioners and hospitals continue to seek out methods to reduce cost structures. The principal force, however, remains the shift of baby boomers into later stages in life, as the number of those ages 55 and older is forecast to expand by nearly 11 million individuals through 2012. More importantly, as the population in general is physically active longer, the number of physicians' office visits among this key cohort is rising, necessitating the demand for more doctors, and consequently more office space.

Medical office assets are expected to weather the current economic storm better than other product types due to heightened consumer demand for health care. In addition, medical office tenants tend to be more stable and stay for longer terms than tenants of other property segments. As such, investor demand for medical office properties remains strong, despite an uncertain economy and restrained lending practices. In addition, unlike many other product classes where sales have deteriorated and cap rates have climbed, investment activity continues to be robust for medical office assets. Through the first half of 2008, sales activity was on par with last year's figures, while cap rates across the country compressed by an average of 30 basis points to 7.1 percent.

Economy: Nearly 440,000 jobs were eliminated during the first six months of 2008, though the pace of reductions will slow through the remainder of the year. Approximately 650,000 positions are expected to be lost, a drop of 0.5 percent. The educational and health services sector, which includes most medical professions, will add more than 300,000 new jobs this year, a 1.8 percent increase.

Demographics: The population of those ages 55 and older continues to grow. Total expansion of 14.3 percent is expected through 2012 in this cohort for an annual average of 2.7 percent, approximately four-and-one-half times the rate of the next fastest-growing age group.

Construction: After roughly 16 million square feet was completed in 2007, developers are forecast to add 17.5 million square feet of medical office space this year. Construction levels remain well above the 8.6 million square feet brought online annually since 2000. The Southwest/Mountain region will lead the nation in construction with 5.1 million square feet, nearly identical to last year.

Vacancy: The U.S. average vacancy rate increased 60 basis points in the first six months of the year, though the rate of declining occupancy is expected to slow through the second half. Vacancy is forecast to rise 80 basis points in 2008, ending the year at 11.1 percent. The most significant increase is forecast in the West/Pacific Northwest region, due to heightened construction levels.

Rents: Robust construction activity and higher vacancy rates will prohibit owners from implementing considerable rent gains through the rest of 2008. Through the second quarter, rents were virtually flat across the nation. Overall, asking rents are forecast to post a modest 1 percent uptick this year to average $23.94 per square foot.

NATIONAL TRENDS

- Demographic Trends: Aging baby boomers will continue to buttress demand for medical office space, as the country's growing need for health care is magnified by an expanding geriatric population. The Southwest/Mountain and Southeast regions, both havens for retirees, are expected to lead the nation in population growth in the 55-plus cohort, gaining just over 20 percent each by 2012 and supporting strong fundamentals in these regions. Investors will want to monitor the progress of medical reform over the next several years as the controversy surrounding universal health care continues. Any reform that could lower the cost of health care would greatly increase the number of people seeking medical treatment, thereby creating the the need for more workers and, in turn, more medical office space.

- Construction Trends: Medical office developers are on track to boost inventories by 17.5 million square feet this year, up from 2007 and almost double the average annual completions since 2000. Growing suburban areas are increasingly popular for medical office development, mainly due to ancillary demand from the construction and expansion of hospitals and regional medical facilities. Additional demand for space has been spurred by the trend toward in-office procedures.

- Rent/Vacancy Trends: Increased deliveries continue to push the nationwide vacancy rate higher. The average rate has climbed 60 basis points since the end of 2007, and another 20 basis point increase is expected by year end. Elevated construction will maintain upward pressure on vacancy well into 2009 as new space fills, with rates hovering in the low-11 percent range. Accordingly, rent growth has stalled, with little to no gains expected until vacancy moderates. Asking rents are expected to finish 2008 at $23.94 per square foot.

- Investment Trends: Solid performance is supporting robust buyer demand for medical office properties. Both transaction and dollar volume have remained essentially unchanged during the first half of 2008, despite the current real estate slowdown. Cap rates have continued to compress and now sit at 7.1 percent, down 30 basis points from the end of 2007. The median price has increased almost 2 percent during the same period to $211 per square foot.

NORTHEAST

- Construction Trends: Developers are on track to deliver 1.9 million square feet in 2008, up from nearly 1.1 million square feet last year. Construction remains concentrated in the Northern New Jersey and New York metros, where builders are targeting a high populace of maturing residents.

- Rent/Vacancy Trends: Demand continues to lag supply as new product precedes occupants. As such, vacancy climbed 70 basis points during the first half of 2008 to 10.2 percent. The result was a 0.4 percent drop in rents over the same period to $24.06 per square foot.

- Investment Trends: Demand for Northeast medical office properties has generated further cap rate compression, while transaction activity for the first six months of 2008 is on par with levels recorded during the same period last year. Cap rates are currently in the mid- to high-6 percent range, down from 7.1 percent at the end of 2007. Assets in suburban locations have taken center stage, resulting in an overall lower median price of approximately $190 per square foot so far in 2008, a 5 percent drop from 2007.

SOUTHEAST

- Construction Trends: Developers are scaling back deliveries this year, with 2.3 million square feet of space scheduled for completion, an 18 percent reduction from 2007. An ever-increasing retiree population in Florida will drive space demand, and developers will respond by building nearly 1.1 million square feet by year end.

- Rent/Vacancy Trends: An uncertain economic outlook has reduced occupancies in the Southeast region, with vacancy rates now hovering in the low- to mid-10 percent range. The rise in vacancy is expected to be short-lived, however, as future demand is buttressed by the region's attractiveness for life after work. Owners have increased rents a modest 1.4 percent so far this year to $23.25 per square foot.

- Investment Trends: An outlook for strong, long-term fundamentals continues to boost property prices. Sales velocity has remained healthy, with activity in the first half slightly above that in the same period of 2007. Cap rates remain in the mid-7 percent range, while the median price has appreciated 3 percent from the end of last year to $210 per square foot.

MIDWEST

- Construction Trends: Developers are on track to deliver 4.5 million square feet of medical office space in 2008, up almost 40 percent from last year. Major metros in Ohio will lead the Midwest, with more than 1.6 million square feet slated for delivery this year, compared with 1.1 million square feet in 2007.

- Rent/Vacancy Trends: Despite a dramatic increase in development, strong demand has kept vacancy in check, rising only 30 basis points during the first half of 2008 to 11.3 percent. The average rent increased 0.2 percent in that time to $20.13 per square foot. Similar trends are expected through the remainder of the year as lease-ups continue.

- Investment Trends: Sustained buyer demand for medical office assets in the Midwest resulted in increased transaction velocity in the first half of 2008. The median price remained unchanged at $142 per square foot since the end of 2007, while cap rates compressed 30 basis points to 7.8 percent.

SOUTHWEST/MOUNTAIN

- Construction Trends: Solid job gains and robust economic growth have generated rapid population expansion throughout much of the Southwest. As a result, developers are expected bring 5.1 million square feet of medical office space online this year, similar to completions in 2007. Builders remain active in the major Texas metro areas, where job growth is leading the nation. Developers are exhibiting increased caution in Phoenix and Tucson.

- Rent/Vacancy Trends: Elevated construction levels have put upward pressure on vacancy, although rates are expected to moderate through theremainder of the year. Vacancy has increased 90 basis points since year-end 2007 to 13.4 percent. The addition of newer Class A inventory helped to push rents up 2.2 percent through the first half of the year to $23.42 per square foot.

- Investment Trends: During the past six months, sales activity for medical office assets has slowed somewhat. The median price remains flat at approximately $198 per square foot, while cap rates are averaging in the high-6 percent range.

WEST/PACIFIC NORTHWEST

- Construction Trends: After bringing 3.3 million square feet of space online in 2007, developers are poised to boost medical office inventory by 3.7 million square feet this year.

- Rent/Vacancy Trends: Although vacancy in the West/Pacific Northwest region has climbed 110 basis points during the past six months, the average rate remains the lowest of all regions at 8.4 percent. Additionally, supply constrained markets, including Los Angeles and San Francisco, feature vacancy rates well below the regional average. Owners have limited rent growth as they wait for space to fill, while some areas have recorded slight declines. Overall, rents have remained essentially flat at $28 per square foot, with minimal movement expected through the remainder of the year.

- Investment Trends: After record activity in 2007, sales have moderated to become more in line with the steady pace posted during the three previous years. Cap rates remain in the low- to mid-6 percent range, while the median price shows no signs of easing, rising 12.5 percent from the end of last year to its current $312 per square foot.

Regional Definitions:
Midwest: Chicago, Cincinnati, Cleveland, Columbus, Detroit, Indianapolis, Milwaukee, Minneapolis
Northeast: Boston, New York City, Northern New Jersey, Philadelphia, Washington, D.C.
Southeast: Atlanta, Charlotte, Orlando, South Florida, Tampa
Mountain/Southwest: Austin, Dallas/Fort Worth, Denver, Houston, Phoenix, Tucson
West/Pacific Northwest: Las Vegas, Los Angeles, Oakland, Orange County, Portland, Riverside-SanBernardino, Sacramento, San Diego, San Francisco, San Jose, Seattle

Labels: Medical Office, Medical Office Buildings, Medical Office Investments, MOB

I just wanted to get this posted, it is some commentary from Rick Santelli at the end of last week on CNBC. I think it is a minor quote, but shows the trends we are seeing in the capital markets right now, with treasury rates dropping but mortgage rates rising. As I've pointed out numerous times, the value of investment real estate is inversely correlated to mortgage rates. The problem we are encountering is that the spreads on mortgages are rising at a faster rate than the index rates are dropping.

Here is his commentary:

"Well, it was a bit weird because last week's auction was so oversubscribed to by investors to buy treasuries, that this week we're seeing why. They wanted the treasuries because they want to dump mortgage securities, and that dynamic, that safety issue, is continuing to keep rates down. And remember people, if you think these lower rates are going to show up in your 15 and 30 year mortgages or your credit card rates, don't hold your breath. When mortgage paper goes one way and treasury goes another, quite simply that's what traders are seeing. What you're going to see is mortgage rates stubbornly moving up against the tidal wave of lower rates in safer government paper."