Commercial real estate not immune but well positioned to withstand economic slowdown and capital markets volatility.

Financial markets and the commercial real estate sector are in the midst of a somewhat unique shift. Similar to past turning points, excesses during the run-up are causing a traditional investor pullback as risk is repriced. During the first quarter of 2008, however, a full-blown credit crunch emerged, with much different characteristics than in past cycles, due to the very nature of the financial engineering that fueled the boom. The pooling of a broad range of home loans, including high-risk subprime mortgages, into Mortgage-Backed Securities (MBS) made it easy and temporarily profitable for lenders to increase originations and relax underwriting standards. Home sales soared well above real demand drivers, leading to overbuilding and significant speculation. Poor risk assessment by ratings agencies and investors in these pools resulted in an underestimation of potential defaults, particularly for adjustable-rate subprime loans that reset at dramatically higher interest rates. The wide use of related complex financial instruments and derivatives tied to MBS further exacerbated the risk and has made it difficult to quantify and reprice the now-troubled portions of these investments. The resulting liquidity crunch emerged as uncertainty regarding the magnitude and true "market" value of these securities pushed investors to the sidelines and led banks to tighten lending standards across the board.

Better Late Than Never: Federal Reserve Actions Wide-Ranging, Aggressive. Fed action, which finally turned aggressive in March, has stabilized financial markets--at least for now. Its measure to prevent Bear Stearns from collapse, in particular, helped stave off a domino effect that clearly could have threatened other major institutions. The reassessment of risk and securities' valuations is well under way, as reflected in massive writedowns. The Fed's steps to restore liquidity, along with interest rate cuts, are also playing a critical role in stabilizing financial markets. Signs of gradual improvement are emerging, including private equity injections into key financial institutions and rising U.S. Treasury yields, indicating investors are slowly taking on more risk. It will take a few more months before the benefits of recent Fed actions are passed along to consumers and businesses, as financial institutions first focus on stabilizing their own positions. The successful refinancing of the majority of maturing fixed-rate U.S. Commercial Mortgage-Backed Securities (CMBS) loans since the start of this year, along with a modest rise in conduit lending in recent weeks reflect some "thawing out" of the previously frozen CMBS sector.

Negative Psychology a Drag on Otherwise Sound Fundamentals. Until late last year, U.S. economic drivers outside of manufacturing and housing had been on relatively solid ground. In the second half of 2007, health care, education, professional services, trade and tourism added 733,000 jobs, while construction, manufacturing and financial services shed 283,000 positions. Negative psychology and tighter credit markets have since eroded consumer and business confidence, triggering a downturn. In the first four months of 2008, companies scaled back capital investments and cut 260,000 jobs, weighing heavily on U.S. consumers already burdened by the housing downturn and high energy prices. The economy has stalled, creating a challenging environment for commercial real estate owners, regardless of whether a technical recession (two or more consecutive quarters of contracting GDP) takes place. The government's stimulus package, liquidity injections and lower interest rates make a technical recession unlikely in 2008 and should foster some growth later this year. In addition, companies avoided excessive hiring and capital investments during the most recent expansion period, supporting expectations for a moderate downturn.

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Commercial Loan Delinquency Still Near Historic Lows. Commercial real estate loan delinquency rates have increased modestly, but at less than 0.5 percent, they remain near historical lows. This is reflective of generally healthy occupancies and income growth during the past few years. Spillover concerns from the troubled residential sector and fears of future problems with late-vintage commercial loans, however, are keeping many CMBS investors on the sidelines. In the first quarter of 2008, commercial banks and life insurance companies tightened underwriting standards further, and some reached capacity limitations. This group of lenders initially helped offset the void created by the CMBS market, and their recent pullback is causing additional constraints on commercial real estate financing. Apartment investors have been impacted the least by the capital markets shift due to increased lending by Fannie Mae and Freddie Mac.

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COMMERCIAL REAL ESTATE OUTLOOK

Fundamentals Rule, Again

The current environment is best defined as a transition from unsustainable, frothy conditions to a "normalized" market, not a systemic crash. Unlike past cycles, generally healthy commercial real estate fundamentals and a lack of significant overbuilding will limit the correction. Furthermore, the last period of economic expansion was relatively brief, and companies remained cautious when hiring and leasing space. That is not to say that occupancies and rents will not suffer from the economic slowdown. Vacancy will rise this year as job losses hinder household formation and companies delay leasing commitments. Unless the downturn deepens unexpectedly, however, the increase in vacancy should be moderate, keeping U.S. averages below previous cyclical highs. Retail is our primary concern, as tenants are directly affected by the housing slump and reduced consumer spending.

Commercial real estate was clearly a beneficiary of the low-interest rate and high-liquidity environment that began in 2002 and ended abruptly in 2007, as reflected in the exceptional rise in sales and values during this period. Subsequently, the credit crunch has caused a sharp drop in activity. The decline is due largely to the near shutdown of the CMBS market, which accounted for nearly half of all commercial lending during the first half of 2007. The high-leverage, speculative investment climate has been replaced by a renewed focus on underwriting to actual operations. Much of this shift back to basics is positive, reducing speculation and development in the long run. In the short term, however, the market will continue to register slower sales due to a classic expectations gap--many sellers are expecting last year's pricing, while many buyers are expecting unrealistic price corrections.

Price adjustments are occurring based on asset quality, market strength and buyers' ability to add value; opportunistic investors awaiting wholesale discounting are at risk of missing opportunities. Cap rates for top-tier assets in primary markets are expected to rise 25 to 50 basis points this year, as the low-leverage, high-quality buyer pool remains capable of acquiring properties for long-term strategies. Cap rates for lower-tier assets and those in secondary/tertiary markets are expected to increase 75 to 100 basis points, or more for higher-risk assets that are challenging to finance. Given the volatility in financial markets, however, downside risks remain present.

Commercial real estate is not immune to volatility in financial markets and the broader economy, but it is well positioned to withstand turbulence for several reasons.

* Debt is constrained but available. Some lenders have reached capacity limitations, and many have tightened underwriting further as they repair balance sheets. Debt capital is available, however, and transactions are occurring across markets and property types for realistically priced assets. Financing terms reflect normalization, with loan-to-values (LTVs) down and debt-service coverage ratios (DSCRs) up from the aggressive levels of 2005 to early 2007 and closer to historical standards.

* Interest rates are low, partially offsetting higher lender spreads. Fed rate cuts, along with recently introduced liquidity measures and the government's stimulus package, will help stabilize financial markets and limit economic contraction. Long-term interest rates will rise as stability returns to the system; however, this should also tighten lender spreads, leaving overall mortgage rates relatively attractive.

* Fundamentals are generally healthy, supply risks contained. Most commercial real estate sectors are entering this period of economic slowing with comparatively low vacancy and several years of healthy rent growth. Assuming the economic downturn is moderate, the rise in vacancies should be less than previous market shifts. Tighter lending standards will limit development, which is already more balanced than in past cycles due to higher construction costs, land scarcity and greater industry transparency.

* Replacement costs are above prices in most markets and property sectors. Despite recent declines in labor, land and certain materials costs, replacement costs remain historically high. In addition, the notion of "replacement" has become a virtual impossibility in more cases than not.

* Distress minimal, equity ample. Cap rate spreads based on property and market quality will expand further this year; however, strong appreciation in recent years will leave owners with substantial equity even after reasonable price corrections. Strong operations are limiting the pool of distressed assets to failed conversions, high-risk developments and speculative transactions closed at the height of the market, which were facilitated by aggressive short-term financing.

* A wide array of capital sources remain active. Notwithstanding the current "wait and see" mood, private investors, particularly aging baby boomers, along with pension funds and foreign investors lifted by the weakened dollar, have ample capital available and remain attracted to U.S. commercial real estate. Investors who sense reasonable risk-adjusted pricing on desirable assets are active in the marketplace. Realistically priced properties marketed to the correct buyer pools are generating plenty of qualified offers and transactions. Sales volume will increase as buyers and sellers recalibrate pricing and financing improves in the second half.

* Beyond the next few quarters, prospects for high single-digit returns are realistic. Turnover of leases signed from 2002 to 2005, when rents were substantially below current levels, will provide a boost to office and industrial NOIs in coning years. A return to economic growth in line with long-term averages, coupled with limitations on new supply, also points to improving returns during the next three to five years.

* U.S. commercial real estate is competitively priced globally. Much of the exceptional rise in U.S. commercial property values since 2002 was due to a structural repricing in the global environment. Cap rate compression in the U.S. largely reflected a "catching up" to yields typical in other developed economies. While cap rates are moving up from historical lows as anticipated and a spread by quality is returning to the marketplace, the drivers summarized above point to cap rates remaining below long-term averages.

Risk levels will remain heightened in the near term. Each downturn has unique characteristics, and this cycle is no exception. Short- to mid-range risks are elevated, as the economy and financial markets are closely entangled in the greatest housing downturn in recent history. The exposure of financial institutions and investor groups, particularly hedge funds, to additional losses is still somewhat unclear. Stubbornly high energy prices are exacerbating the issues. While the weak dollar is helping to offset the impact of the housing downturn through increased exports, it is also driving up oil prices. Should an oil supply shock occur, prices would rise further, potentially deepening the economic downturn.

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ECONOMIC OUTLOOK

The Age of Resilience and Moderation.

The most pervasive theme of U.S. economic performance in the past 20 years can be summed up in a single word: resilience. From the stock market crash of 1987, the collapse of the Savings and Loan industry and recession in 1990/91, the Asian financial crisis in 1997/98, the dot-corn collapse in 2001 and the 9/11 tragedies, to a wave of corporate scandals and job offshoring, the U.S. economy has demonstrated its agility, innovation and better-than-expected performance after each shock.

The serious and unique challenges of the current downturn should not be underestimated; however, if past tendencies to address problems through market forces and government intervention are any indication, a prolonged period of economic contraction is unlikely. By the same measure, a "snap-back" recovery is not expected, as many of the current issues, particularly housing, will take time to correct. What started out as a subprime mortgage problem has ballooned into marketwide negative psychology and reversal of the housing-wealth factor. As prices fall, more financially-able homeowners with little or negative equity are walking away from their mortgages, driving further price correction. Therefore, housing and its impact on financial markets will remain wildcards for the next several months.

Housing Market Yet to Hit Bottom. Existing home sales continued to decline through the first several months of 2008. On a year-ago basis, home prices are down 8 percent, and sales activity is off by 18 percent. For-sale inventory recently increased to a new record-high of more than 11 months of supply. Nationwide, the housing market should settle late this year as the economy improves and credit conditions for qualified homebuyers ease, though the most oversupplied markets will not hit bottom until 2009. Overall, price reductions and low interest rates should spur buying activity, which, coupled with further slowing in housing starts, will reduce for-sale inventory next year.

Inflation Risks Elevated. A potential side effect of Fed easing is rising inflation, which points to a tightening campaign quickly upon normalization of the economy. The headline rate of inflation remains elevated at 4 percent, but core inflation is only 2.4 percent, which means high energy costs have not yet translated into significantly higher prices for non-energy-related goods. Oil prices climbed considerably in the first quarter, however, and companies will ultimately need to pass higher energy costs on to consumers. If the Fed's expectation of easing inflationary pressures due to a slower economy fails to materialize, it may be forced to raise interest rates rapidly, creating a new round of economic headwinds.

Modest Job Growth Expected. The U.S. job market registered four consecutive months of net losses in early 2008, and further contraction is likely in the near term. Payrolls are forecast to resume growth in the second hall however, as the positive effects of fiscal and monetary stimuli take hold. Education, health care, exports and tourism are forecast to remain the top drivers of growth, with weakness concentrated in manufacturing, construction, banking and housing-related industries.

Corporate Profits Weaken, but Balance Sheets Still Sturdy. Domestic corporate profits declined in the second half of 2007, due mainly to financial sector losses; however, profits from overseas operations registered the strongest gain since 1980. Outside of the financial sector, profit margins are still generally healthy, and many companies have significant cash reserves after several years of double-digit profit growth. Across the board, businesses should get some relief from easing wage pressures as slack returns to the labor market.

Weak Dollar Driving Exports. The U.S. dollar has declined nearly 30 percent against major foreign currencies since 2002. Though disconcerting to many Americans, the weak dollar is lending support to the U.S. economy. Foreign demand for U.S. goods has increased, narrowing the trade gap and contributing to GDP growth. Port markets and transportation hubs will benefit from this trend, and favorable exchange rates will encourage international travel to the United States, reducing the impact of slower U.S. consumer spending on the hospitality and retail sectors in gateway cities.

CAPITAL MARKETS TRENDS

The Fed has become aggressive in its efforts to contain the downturn and prevent a financial sector crash. In April, the Fed cut rates by an additional 25 basis points and continued its work with foreign central banks to restore liquidity. The Fed also extended its term auction facility, which is designed to encourage borrowing by banks, and launched a new facility that allows securities firms to borrow from the Fed using difficult-to-trade agency mortgage-backed securities as collateral. In an unexpected move to prevent further deterioration in the financial sector, the Fed also extended credit to J.P. Morgan Chase to support the acquisition of struggling Bear Steams.

Reality Sets In. Until last summer, strong secondary market demand for mortgages allowed lenders to continuously replenish capital. Lenders are now proceeding with caution, basing underwriting on actual NOIs as opposed to pro forma figures and raising equity requirements. Lenders are also placing greater weight on property quality and location, shying away from riskier deals that rely heavily on future rent and occupancy gains. Financing properties in tertiary markets has become most challenging, with many major lenders avoiding these markets altogether. On average, LTVs have declined from 75 to 80 percent to 60 to 70 percent, while DSCRs have increased to 1.2x or greater, up from 1.1x, or break-even in some cases, as recently as mid-2007.

Uncertainty Causing Frequent, Often Exaggerated Spread Movement. Investors will remain highly reactive to economic indicators in the near term, causing continued volatility across financial markets. Lender spreads have been fluctuating in a wide band since last summer, with moves of 50 basis points in one day not uncommon. In early May, conduits began to slowly re-enter the marketplace, with spreads at 325 to 400 basis points or more over the 10-year Treasury. Portfolio lender spreads have also narrowed and remain competitive compared to conduits, at 225 to 275 basis points over the 10-year Treasury for apartments and 225 to 320 basis points over for other property types. Apartment investors have the advantage of using Freddie Mac and Fannie Mae, which are pricing loans at 210 to 255 basis points over the 10-year.

Commercial Mortgage Origination Volume Reflects Tighter Financing Climate. First quarter originations were dramatically below year-ago levels. The financial market shock caused commercial mortgage origination volume to fall 17 percent in the second half of last year when compared to the previous six-month period. The decline, however, was due entirely to conduit lenders. While the CMBS market recently began showing signs of life, the sector first needs to work through a backlog of an estimated $30 billion of mortgages before a true recovery cycle can gain traction. Some of the loans in the pipeline were originated prior to the tightening of lending standards, making new issues difficult to price. It is important to note that even after the drop in originations in the second half of 2007, lending activity was still up 37 percent from just three years earlier. It will take some time for the securitization model to be redefined as a source of capital, but the benefits of this vehicle prior to the frenzy will most likely result in its return to the marketplace in some form.

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Lack of Overall Distress Preventing Unreasonable Price Corrections. On average, longer-term loans nearing maturity were originated at least five years ago, during which time owners recorded substantial increases in incomes and values. Refinancing for these assets, even in today's tighter environment, is available as a result. Loans issued in the 12 to 18 months leading up to the market shift had the most aggressive underwriting, but many of these mortgages featured interest-only periods of three to five years, providing operators time to work through the economic downturn. Some of these aggressively financed assets in the hardest-hit local economies are likely to default in the near term, though this is unlikely to cause an overall, systemic distressed environment.

Low Interest Rates Helping Offset Higher Spreads. The yield on the 10-year Treasury fell to a low of 3.3 percent in March but has since increased; however, at approximately 4 percent, it is still 125 basis points below last summer. Despite concerns surrounding the weak dollar and inflation, investors will continue to look to U.S. Treasurys as a safer alternative to stocks, which have been prone to dramatic swings. As a result, the 10-year is forecast to end 2008 in the high-3 to low-4 percent range.

REAL ESTATE MARKET FUNDAMENTALS

Unlike the last prolonged liquidity crunch in the early 1990s, which was caused by massive overbuilding, the commercial real estate market today is generally well balanced. Slower economic growth will cause softening in fundamentals, but supply-side risks will decline as the development pipeline narrows due to caution and more stringent lending requirements.

APARTMENT MARKET

Rising Competition from Shadow Rentals. Apartment owners have more competition from for-rent condos and single-family homes, particularly in oversupplied housing markets in the Southeast and Southwest. The number of vacant condos and houses surged in the first quarter of 2008, due in part to a spike in foreclosures. Metro areas with the highest homeowner vacancy rates include Orlando, Tampa, Las Vegas, Atlanta and Jacksonville, though Phoenix, Riverside-San Bernardino, Sacramento and Miami also rank in the top tier. The lowest homeowner vacancy rates are generally in supply-constrained coastal markets, such as Seattle, Los Angeles, San Francisco, New York, Philadelphia and Boston. Fortunately for apartment owners, banks typically shy away from residential property management; therefore, most foreclosures will not hit the rental market directly. Furthermore, many for-rent houses are in far-reaching suburbs, which given high gas prices are now less attractive to prospective renters.

Reversing Homeownership and Demographic Shifts Boost Renter Demand. Between early 2000 and year-end 2004, total renter households declined by 1.9 million, as the homeownership rate increased from 66.9 percent to 69 percent; however, the trend began to reverse in 2005. Since then, the homeownership rate has fallen to 67.8 percent, which translates to 2.6 million households that required alternative housing. The reversal is most pronounced in younger age cohorts, which typically account for a large share of renters, helping offset com petition from shadow stock. Apartment owners will' also benefit from the emerging echo boom generation, who have just begun to enter their prime renting years. Most mortgage companies have eliminated riskier first-time homebuyer programs and require higher downpayments, reducing the pool of potential buyers able to qualify.

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Completions Rising but Still Restrained by Historical Standards. Developers will deliver 102,000 apartments in 2008, up from 86,200 units in 2007. In addition, several conversion projects have returned to apartment stock in recent quarters. Despite the rise in new supply, development activity in 2008 will remain low compared to the late 1990s to 2003, when deliveries reached an annual average of 150,000 units. Construction starts are likely to fall due to the slower economy and tighter financing climate, however, potentially resulting in a shortage of units during the next three years.

Moderate Increase in Vacancy Expected. Vacancy increased 30 basis points to 5.9 percent in the first quarter due to seasonal fluctuations and job losses. An additional 20 basis point increase to 6.1 percent is expected by year end as the softer employment market limits household formation and forces some renters to double-up. The Class B/C market will remain the most stable as slower economic growth and high energy costs limit renters' options. Class A assets will benefit from reduced migration of renters to homeownership but also face greater competition from shadow rentals, which will push vacancy higher. Marketwide, modest softening will result in increased concessions.

RETAIL MARKET

Consumers Pull Back. Retail sales growth stalled in the first quarter but is forecast to reach 2.5 percent for the year, down from 4.1 percent in 2007 and a cyclical high of 6.6 percent in 2005. Consumers supported the economy during the past several years with the help of low interest rates, rapid home price appreciation and equity withdrawal. Cash-out refinancing activity was down 50 percent last quarter when compared to one year earlier and is forecast to slip further. Household budgets are also getting squeezed by elevated energy costs and, in some instances, higher mortgage payments due to ARM resets.

Retailers Cut Expansion Plans, Development Declining. Retail vacancy increased 40 basis points in the first quarter to 10.1 percent. Fortunately, development has been largely tenant driven in recent years, and tighter lending will limit speculative development further as this year progresses. Nonetheless, vacancy is expected to rise by an additional 100 basis points this year to 11.1 percent, following a 90 basis point increase in 2007. Smaller retailers will be the most negatively affected by the slowdown in consumer spending growth, though many larger chains have announced closures.

Markets with the Greatest Near-Term Challenges Boast Strong Long-Range Prospects. Retail developers followed home builders into far-reaching suburbs of high-growth markets such as Phoenix, Las Vegas, Sacramento and Riverside-San Bernardino. Some retail properties may fall short of expectations as a result, with many new homes vacant and a glut of unsold residential lots in inventory. Fortunately, extended household and job growth forecasts for the hardest-hit housing markets are among the healthiest in the nation.

Reduced Inflow of Exchange Capital Limiting Single-Tenant Sales. Exchange capital coming out of apartments, particularly from California, provided a boost to the single-tenant retail market in recent years. While single-tenant assets with national credit tenants remain in strong demand, the pool of private investors targeting these assets has been limited by the decline in transactions in other property sectors.

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INDUSTRIAL MARKET

Slower Development and Healthy Export Activity to Limit Rise in Vacancy. Following a 150 basis point decrease between 2002 and 2007, industrial vacancy increased 20 basis points in the first quarter of 2008 to 9.7 percent. During the balance of the year, vacancy is forecast to tick up an additional 50 basis points. While completions are expected to decline to 148 million square feet this year, compared to 160 million square feet in 2007, only one-third of the new industrial space under way has been pre-leased.

Exports Providing Boost to Industrial Demand. The weak dollar is generating healthy foreign demand for U.S. goods, lending support to industrial demand as domestic consumers pull back on spending. Net exports in 2007 made a positive contribution to annual GDP growth for the first time since 1991, a trend forecast to continue through 2008, albeit to a lesser degree.

Tenants Favoring Newer Properties. Companies are facing higher production and fuel costs, creating a need to improve efficiencies in the distribution process. Newer warehouse properties typically feature greater clear heights, larger docking areas, and often fiber optics for communications and power systems to run high-tech equipment. Vacancy rates for properties built in 2005 or later have declined in recent years, while vacancy among older assets has steadily increased.

OFFICE MARKET

Completions on the Rise in 2008, but Planning Pipeline Narrowing. Office construction is expected to rise this year but will remain well below levels recorded from 1999 to 2001, when an average of 125 million square feet of new space was brought online annually. This year, office deliveries will total 63 million square feet, up from 54 million square feet in 2007. The pipeline is thinning, however, with 45 percent less space in the pre-planning phase than one year ago.

Moderate Softening in Fundamentals Expected After Strong Recovery Cycle. Vacancy increased 20 basis points during the first quarter to 12.8 percent and is forecast to reach 13.8 percent by year end. After declining for 17 consecutive quarters, vacancy began trending up in late 2007 as the financial industry absorbed the impact of subprime losses. Despite the recent uptick, vacancy remained low enough to support a more than 10 percent gain in effective rents last year, the strongest growth since 2000, and rents continued to rise in early 2008. Slower job creation and rising competition from the sublease market, however, will limit effective rent growth this year to between 3.5 percent and 3.0 percent.

Previously Hot Housing Markets Taking Greatest Hit from Subprime Meltdown. Fallout from the subprime debacle is causing mass layoffs among banks and real estate services companies. This trend is impacting office space demand in primary financial hubs, including New York, Chicago and San Francisco, in addition to previously strong housing markets, such as Orange County, Phoenix, Las Vegas and Riverside-San Bernardino. In addition to reduced demand, increases in sublease availability are expected, particularly in higher-growth suburbs. Nationwide, sublease space as a percent of total vacancy bottomed at 8 percent in early 2007 but has begun to inch up.