Real Estate Investment Research

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1 21 National Real Estate Investment Research Office Report

2 21 National Office Report To our valued clients: Recovery from the Great Recession promises to be muted and choppy, a departure from previous significant 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. Corporate conservatism will persist through at least the first half of the year, but businesses should begin to pick up slack in the economy as 21 progresses. This expectation is supported by healthy corporate balance sheets and record levels of excess cash. The major wild card is whether enough confidence will emerge to take corporate America into a true expansion mode. This shift will occur at some point, possibly beyond 21, leading to the redeployment of capital, which, in turn, will fuel hiring and absorption of office space. The severity of job losses during the recession overshadowed the lack of overbuilding in the office sector, pushing vacancies to levels similar to those recorded after the 21 recession and not far off from the 199s crisis. Vacancies are still rising, but the pace has slowed, and 21 should mark the peak for this cycle, with at least a gradual recovery in 211. The expiration of leases signed during the height of the last expansion period will drag on NOIs for the next few years but should be somewhat offset by a release of pent-up demand through above-average job growth between 211 and 213. Office investment activity ticked up modestly in recent quarters after coming to a near standstill in the first part of 29. Buyers, no longer concerned with timing the market s bottom, have been drawn back into the marketplace by some of the most attractive prices and cap rates this decade. Thus far, however, renewed investor interest has been confined mainly to top-quality assets in primary markets. Despite stronger buyer demand, credit markets remain tight, limiting the acceleration in sales velocity and the scope of deals that can move forward without assumable or seller-financing. There are some encouraging signs in the lending arena, including renewed activity in the CMBS sector and fewer false starts for new loans, reflecting greater clarity on property valuations and lenders requirements. Community and regional banks, which have become a key source of funding for office investors in recent years, present a significant near-term hurdle as commercial real estate losses accelerate and congressional scrutiny intensifies. Quality will continue to dominate investors and lenders decisions, leading to further divergence in prices and cap rates this year. Expectations of high-quality assets coming to market through large volumes of distressed sales continue to exceed the reality as lenders opt to modify and extend loans as much as possible to avoid further losses. Limited distressed sales are slowly helping the market reset values. To assist you in planning and executing a successful investment strategy, we are pleased to present our 21 National Office Report. Included is our National Office Property Index (NOPI), a forward-looking ranking of 44 markets based on forecast supply and demand conditions. We hope you will find this report helpful, and our investment professionals look forward to assisting you in meeting your goals. Sincerely, Harvey E. Green President and Chief Executive Officer Hessam Nadji Managing Director Research Services

3 21 National Office Report NATIONAL PERSPECTIVE Executive Summary... 3 National Office Property Index National Economy... 6 National Office Overview... 7 Capital Markets... 8 Investment Outlook... 9 MARKET OVERVIEWS Atlanta... 1 Austin Boston Charlotte Chicago Cincinnati Cleveland Columbus Dallas/Fort Worth Denver Detroit... 2 Fort Lauderdale Houston Indianapolis Jacksonville Kansas City Las Vegas Los Angeles Louisville Miami Milwaukee... 3 Minneapolis-St. Paul Statistical Summary Table New Haven New Jersey New York City Oakland Orange County Orlando Philadelphia... 4 Phoenix Portland Riverside-San Bernardino Sacramento Salt Lake City San Antonio San Diego San Francisco San Jose Seattle... 5 St. Louis Tampa Tucson Washington, D.C West Palm Beach Medical Office Outlook CLIENT SERVICES Office Locations National Office and Industrial Properties Group (NOIPG)... 6 Marcus & Millichap Capital Corporation Contacts, Sources and Definitions Research Services Written by John Chang, National Research Manager, and edited by Hessam Nadji, Managing Director. The Capital Markets section was coauthored by William E. Hughes, Managing Director, Marcus & Millichap Capital Corporation. Additional contributions were made by Marcus & Millichap market analysts and investment brokerage professionals nationwide. 21 Annual Report

4 21 National Office Report Executive Summary National Office Property Index (NOPI) Washington, D.C., retained the top spot of the NOPI in 21, fueled by healthy job gains and the greatest positive net absorption of any market in the ranking. Philadelphia (#2) also maintained its position from a year ago due to a second consecutive year of modest supply growth and an increase in office-using employment. Markets with high concentrations of banking and finance-related jobs generally improved in this year s ranking, led by New York City (#6), which rose two spots. San Francisco (#15) and Charlotte (#16) climbed four and two positions, respectively. With a few notable exceptions, demand for office space remains unlikely to pick up considerably this year, even as employers expand payrolls. Reflecting the shallow anticipated absorption, markets that avoided significant speculative development and retained lower vacancy rates throughout the recession, such as Los Angeles (#3), Boston (#5) and Portland (#7), ranked highly in the index. National Economy The recession claimed 8.4 million jobs, including more than 4.8 million positions in 29. Employers will rehire cautiously in 21, creating 1 million jobs, with office-using industries accounting for approximately one-third of the total. Government stimulus, healthy trade activity and stabilization of the housing market point to gross domestic product (GDP) growth of 2.5 percent to 3. percent in 21. Another year of below-trend personal consumption, which accounts for more than 7 percent of economic activity, dampens the likelihood of a significant near-term rebound in GDP. The second half of 21 will mark an important turning point for the U.S. economy, as real growth drivers, not government stimulus and incentive programs, will need to take over as primary drivers of expansion. National Office Market Overview New supply will not significantly affect property fundamentals in many markets, as completions will total 3 million square feet, down from 45 million square feet in 29. Despite limited construction and the resumption of office-using job creation, vacancy will rise 1 basis points to 18 percent in 21. Leases on roughly 13 percent of occupied space are due to expire in 21, and owners with rollover risk further softening of NOIs if tenants scale back space needs to reflect current staffing. National asking rents will fall 3.5 percent this year, following a 4.7 percent dip in 29, while effective rents will decrease 5.2 percent, after plunging 8.9 percent last year. Headwinds to NOIs will persist for several years. Substantial rent declines will occur in some prominent CBDs, such as Midtown in New York City and the Financial District in San Francisco. Rents in these areas spiked from 25 to 27 but continue to recede as many owners employ discounts and concessions rather than realize a loss of revenues from vacant space. Capital Markets Lenders will continue quoting all-in rates instead of spreads over Treasuries, limiting fluctuations in borrowing costs. All-in rates for new five-year mortgages currently range from 6.5 percent to 7. percent. On average, LTVs are 6 percent to 65 percent. Tight lending among traditional sources of mortgage debt will result in a growing number of IPOs this year. Many REITs will tap the stock market to pay down existing debt or raise capital for acquisitions. CMBS holds promise for improved liquidity in the office sector this year, with several lenders ramping up conduit lending operations; however, the securitization market will not resume its role as a primary source of financing in the near future. Investment Outlook With banks offering modifications and extensions of up to three years on average, distressed deals may make headlines but will not account for a significant share of investment activity. Buyer motivation will shift in 21 from trying to time the market s bottom and acquire assets for pennies on the dollar to a more thoughtful evaluation of short- and long-term opportunities. Following a 5 percent decline last year, investment activity is expected to accelerate in 21, but transaction volume will lag the peak levels of a few years ago. Medical office assets posted comparatively stable occupancy and rents through the recession, stimulating investment demand and limiting price declines. Cap rates for medical office properties have inched up an average of just 1 basis points since 27, while the median price has dropped 12 percent, compared with a 25 percent fall for traditional office properties. Medical office buildings comprised nearly half of all sales activity in many secondary and tertiary markets last year. 21 Annual Report page 3

5 National Office Property Index Markets with the Greatest Expected 21 Employment Growth San Antonio Austin Dallas/Fort Worth Chicago Seattle Houston Portland Riverside-SB San Diego Charlotte United States.7% 1.4% 2.1% 2.8% Employment (Y-O-Y Change) Millions of Square Feet Markets with the Highest Expected 21 Completions Washington, D.C. Charlotte New York City Atlanta Dallas/Fort Worth Miami Houston Phoenix Denver San Francisco Rate Rate 18% 16% 14% 12% 1 32% 28% 24% 2 16% Markets with the Greatest Expected 21 Employment Losses Milwaukee New Haven Jacksonville New Jersey West Palm Beach Detroit Cleveland Miami Fort Lauderdale Orlando United States % 1.5% 3. Employment (Y-O-Y Change) Markets with the Lowest Expected 21 Rates Markets with the Highest Expected 21 Rates New York City Los Angeles Washington, D.C. Philadelphia Boston Tucson Portland San Francisco Detroit Houston Riverside-SB Miami Phoenix Las Vegas Dallas/Fort Worth Tampa Jacksonville San Jose Denver Sacramento 21 National Office Property Index Marcus & Millichap is pleased to present the 21 edition of the National Office Property Index (NOPI), an analysis that ranks 44 office markets based on a series of 12-month forward-looking supply and demand indicators. Markets are ranked according to their cumulative weighted-average scores for various indicators, including projected office-using employment growth, construction, net absorption, revenue change and vacancy. Taking into account both the level and degree of change of multiple variables over the forecast period, the index is designed to indicate our expectations for this year s supply and demand conditions at the market level. Users of the index are cautioned to keep several important points in mind. First, the index is not designed to predict the performance of individual investments. A carefully selected property in the bottom-ranked market could easily outperform a poor choice in the top-ranked market. Second, the index is geared toward a short-term time horizon. A market facing difficulties in the near term may provide excellent long-term prospects, and vice versa. Third, a market s ranking may improve from one year to the next even if its operating fundamentals are worsening. This year, for example, space demand will be weak in most markets, and many will record considerable rent declines. The ranking weighs the relative health of all markets and the lingering effects of the economic downturn on property performance. It is also important to note that because the NOPI is an ordinal index, differences in specific rankings should not be misinterpreted. For example, the top-ranked office market is not necessarily twice as good as the secondranked market, nor is it 1 times better than the 1th-ranked market. Degree of Supply and Demand Imbalance Separates Top Markets All 44 office markets in the 21 index will register vacancy increases and rent reductions this year, as the effects of the recession continue to impact office space usage. As a result, performance of individual markets in the NOPI this year is determined largely by the extent of supply/ demand imbalance. Even after accounting for further softening in fundamentals, vacancy rates will remain comparatively low in top-ranked markets, such as Washington, D.C., Philadelphia and Houston, which will benefit from above-average job creation this year. Lower-ranked markets, such as Atlanta and Austin, where speculative construction has come online in recent years, will require some time for tenants to absorb excess space, causing high vacancy to persist in the near term. page 4 21 Annual Report

6 National Office Property Index Millions of Square Feet Markets with the Highest Expected 21 Absorption Washington, D.C. Charlotte Miami Minneapolis-St. Paul San Antonio Portland San Francisco Seattle Austin San Diego Washington, D.C., and Philadelphia Claim Top Spots Again Washington, D.C., returns at the head of the NOPI in 21 as job growth, especially among government-related sectors, supports indexleading absorption this year. Philadelphia (#2) also maintained its position as a result of modest supply growth and a moderating decline in revenue, while minimal completions and the second-lowest vacancy rate elevated Los Angeles two spots to #3. Houston (#4) and Boston (#5) round out the top five, though the latter slipped two places from 29 amid expectations for an above-average decline in revenue. New York City (#6) moved up two positions in the 21 NOPI on forecasts for the onset of recovery in the market s financial services sector and limited inventory growth. Strong office-using employment additions and modestly positive net absorption fueled Portland s three-spot rise to #7. Kansas City slipped two places but still ranks highly at #8 due to expectations for only a minimal increase to its vacancy rate this year. Chicago, however, gained three spots to #9 based on forecasts of the strongest absolute office-using job creation of any market in the index. Seattle, which will record a minimal uptick in vacancy this year, inched up one spot to #1. San Diego leads the group of markets ranked just outside of the top 1 with above-average marks for several indicators, including its change in vacancy, concessions and new supply. Nine of the markets placing from #11 to #2 will register an increase in office-using employment in 21, following an aggregate loss of approximately 112, positions in these metro areas last year. In San Antonio (#13), 4,9 positions will be added in 21, nearly offsetting cutbacks in 29, while employers in San Francisco (#15) will hire 2, office workers after shedding 15,9 jobs last year. Charlotte rose two positions in the index to #16 as the effects of banking industry consolidation on the market s fundamentals have been less severe than initially anticipated, while New Jersey fell nine positions to #18 due to continuing, albeit moderating, employment reductions and soft space demand. A recovery may begin sooner than expected, however, if the New York City market bounces back vigorously. The lower half of the NOPI generally consists of markets where disparities between supply growth and demand will lead to considerable increases in vacancy rates. Markets significantly affected by the housing downturn and resulting decline in housing-related office employment also make up the bottom half of the index. These markets include Sacramento (#36), Phoenix (#38), Riverside-San Bernardino (#4) and Las Vegas (#42), as well as major Florida metro areas. Markets in the state will not recover this year, but properties acquired here in 21 could offer strong upside for less risk-averse investors. Rank Rank 9-1 MSA Change Washington, D.C. 1 1 Philadelphia 2 2 Los Angeles Houston 4 4 Boston New York City Portland Kansas City Chicago Seattle San Diego Louisville San Antonio Salt Lake City San Francisco Charlotte Minneapolis-St. Paul New Jersey Tucson Indianapolis 2 2 St. Louis Oakland New Haven Austin Orange County San Jose Dallas/Fort Worth Miami Milwaukee Denver Atlanta Cincinnati Orlando Cleveland Columbus Sacramento Fort Lauderdale Phoenix West Palm Beach Riverside-San Bernardino Tampa Las Vegas Jacksonville Detroit See National Office Property Index Note on page Annual Report page 5

7 National Economy 6% 3% -3% -6% 8 Employment * Prolonged Recession; Businesses Pull Back U.S. GDP (Ann. Qtrly. Chg.) Unemployment & Core CPI (Y-O-Y Chg.) 1 5% -5% U.S. GDP Fixed Nonresidential Investment % -25% -5 9 Long-Term U.S. Industrial Production 16% 8% -8% -16% 74 Inflation Threat Minimal For Now 16% 12% 8% 4% Unemployment Rate Core CPI Capacity Utilization 85 Recessions 9 9 ** Through January Fixed Nonres. Inv. (Ann. Qtrly. Chg.) 1** Capacity Utilization 21 a Staging Year for Eventual, Sustainable Economic Expansion Cycle After a fourth quarter 29 rebound in U.S. GDP, largely attributable to temporary factors, moderate economic expansion will resume, setting the stage for more robust growth in 211. The greatest contributions to fourth quarter GDP came from stabilizing business inventories after a steep liquidation cycle and government stimulus, the impact of which will fade dramatically by midyear. The second half of 21 will mark an important turning point for the U.S. economy, as real growth drivers, not government stimulus and incentive programs, will need to take over as primary drivers of expansion. With consumers likely to remain cornered by weakened balance sheets, drastically reduced home prices and extremely tight credit markets, the onset of a sustainable recovery will hinge on businesses shifting out of survival mode and putting stockpiled cash back to work. Since companies are running lean, even modest improvements in demand should translate into inventory and payroll increases and ultimately encourage investment in new equipment following a prolonged period of conservation. Another economic boost may come from proposed legislation aimed at improving the availability and size of SBA loans. While 21 will most likely be viewed as a period of modest growth in advance of sustainable recovery, the economy could present an upside surprise later this year. Extreme job cuts in 28 and 29 eventually will give way to a shortage of workers, which may lead to more robust job creation as soon as the second half of 21, earlier than currently anticipated. As it stands, financial services accounts for the smallest share of nonfarm employment since the late 199s, and overall office-using employment has reverted to levels last seen in 22. Despite support for cautious optimism, office property owners will experience another year of depressed NOIs. While employment growth will resume this year, the full impact of job cuts has yet to be factored into office vacancy. Leases on roughly 13 percent of occupied space will expire in 21, and owners with rollover risk another operational hit if tenants scale back space needs to reflect current staffing. 21 National Economic Outlook Muted Recovery Sustainable. Government stimulus, healthy trade activity and stabilization of the housing market point to GDP growth of 2.5 percent to 3. percent in 21. Another year of modest personal consumption, which accounts for more than 7 percent of economic activity, dampens the likelihood of a significant near-term rebound in GDP. Employment Growth to Resume, Albeit Below Trend. The recession claimed 8.4 million jobs, including 4.8 million in 29. Employers will rehire cautiously in 21, creating 1 million positions, with office-using sectors accounting for nearly one-third. A recent four-month swell in temporaryhelp hiring, totaling almost 25, jobs, suggests manpower needs have increased but reflects companies reluctance to commit to full-time employees. Tame Inflation Outlook. The doubling of the Fed s balance sheet since late 28 provides cause for long-term inflation concerns; however, elevated unemployment and low capacity utilization will mitigate the risks through most, if not all, of 21. Fed Maintains Accommodative Stance. The central bank will soon be charged with determining when and how much support to withdraw without causing another recession. Barring an unexpected spike in inflation, the Fed is likely to hold interest rates at or near current levels this year, though they will allow many credit facilities to expire. page 6 21 Annual Report

8 National Office Overview Office Vacancies to Stabilize by Year End; NOI Recovery Facing Headwinds The loss of more than 2 million office-using jobs in the past two years has adversely affected office property performance, but vacancy increases and rent reductions will moderate as 21 progresses. Office-using employment will grow in many markets, setting the stage for improved space demand as the economic recovery accelerates. Initially, however, tenants who trimmed work forces during the recession will fill empty cubicles before considering expansions, and under-utilized space may not dissipate quickly. In addition, near-term lease renewals may result in less occupied space than was needed before the recession, when payrolls were larger. While conditions supporting an improvement in fundamentals may emerge sooner than expected, under-utilized space and the potential for many tenants to shrink requirements will likely underpin a drop in occupied space in 21. Square Feet Completed (millions) Office Construction * With additional negative absorption looming this year, rents could face sizable cuts on renewals of leases signed at the office sector s most recent peak. Substantial rent declines also will occur in some prominent CBDs, such as Midtown in New York City and the Financial District in San Francisco. Rents in these areas climbed from 25 to 27 but continue to recede as owners employ discounts and concessions rather than realize a loss of revenues from vacant space. As rents fall, development of new space will ease further. This year, supply growth will not significantly affect property fundamentals in many markets, as completions will total 3 million square feet, a.7 percent increase to inventory and a drop from 45 million square feet in 29. Minimal new supply in large markets such as Boston, Chicago, Houston and Los Angeles will set the stage for recovery as demand improves in 211. Square Feet Absorbed (millions) Office Absorption and 16 Net Absorption Rate 24% % -8 12% -16 8% * Rate 21 National Office Market Outlook Employment to Increase. Office-using employers will create 3, jobs this year, a modest increase compared with previous recoveries and an amount unlikely to generate much new space demand. During the most recent recovery from 24 to 2, an average of 645, office-using workers were hired annually. In the 1992 to 2 expansion, 928, office-using jobs were added each year. to Rise; Rents to Decline. will increase 1 basis points to 18 percent in 21 on negative net absorption of 16.2 million square feet, compared with negative net absorption of 82.6 million square feet last year. Markets such as Washington, D.C., and Chicago will record below-average vacancy increases due to employment growth and reduced construction. National asking rents will fall 3.5 percent this year, following a 4.7 percent dip in 29, while effective rents will decrease 5.2 percent, after plunging 8.9 percent last year. Class B/C Space Pressured. Lower-tier space typically fills late in the property cycle and empties early in the downturn. Roughly 7 percent of the decline in occupied space over the past two years occurred in Class B/C product, and demand will stay weak in 21. Reduced Class A rents will encourage some tenants to upgrade, while the creation of new businesses that may occupy low-cost space remains mired by tight credit and elevated risk aversion. More Markets in Operational Distress. This year, 15 markets will record vacancy of 2 percent or more, up from only three markets two years ago. Residential boom-towns Las Vegas, Phoenix and Riverside-San Bernardino head the list, as severe drop-offs in residential real estate and construction-related employment have pressed vacancies above 25 percent in each market. Concessions as a % of s Square Feet Absorbed (millions) 25% 2 15% 1 5% Office Net Absorption by Property Class Concessions as a Percentage of s 97 Class A 99 1 Class B/C % 8% -8% -16% * 9 Y-O-Y Change in s 21 Annual Report page 7

9 Capital Markets 6+ Days Delinquent* Index Value (21 = 1) 2 15% 1 page 8 Office Mortgage Originations Index Office CMBS Delinquency Rates Highest and Lowest by MSA 5% 4 Phoenix Las Vegas 5 Riverside-SB Orlando Minneapolis- St. Paul Based on National Office Report markets Average Portland 7 8 Tucson Salt Lake City Seattle San Diego Economic Risks Expected to Outweigh Inflation Concerns in the Short- to Midterm Core Inflation & Interest Rates 8% 6% 4% 2% 1 2 Core Inflation 1-Year Treasury Fed Funds Rate 3 4 Estimated Commercial Mortgage Maturities by Vintage Mortgage Maturities (billions) $24 $18 $12 $6 $ * 1Q 21 Estimate Pre Tight Underwriting, Constrained Lending Persist, but Encouraging Signs Emerge New commercial mortgage applications lead to fewer false starts today than one year ago, reflecting greater confidence in office market forecasts and increased clarity of lenders underwriting criteria and borrower requirements. This trend marks an important step toward price discovery, which will continue as 21 progresses, ultimately driving a self-perpetuating acceleration in investment activity. Nonetheless, new financing will remain challenging to secure this year, leading more investors to properties with assumable or seller financing. Among traditional lenders, community/regional banks will maintain the financing lead this year, though lending will pick up among other sources. Life insurance companies started 21 with increased allocations to commercial real estate, but stringent underwriting criteria and high downpayment requirements will limit their scope to top-tier assets in primary markets and the strongest of borrowers. The long-stalled CMBS market began to show signs of life late in 29, when a handful of single-borrower/ multi-property deals came to market. While CMBS holds promise for improved liquidity in the office sector this year, with several lenders ramping up conduit lending operations, the securitization market will not resume its role as a primary source of financing in the foreseeable future. Furthermore, unlike frothy pre-credit-crunch conditions, conduit lenders will need to adhere to strict underwriting standards to effectively market newly issued debt. Office CMBS delinquency surpassed 4 percent at the start of 21 and will rise further. At present, over 7 percent of outstanding CMBS loans report debt-service coverage ratios of less than 1., and nearly one-quarter have been placed on ratings watch lists. In addition, a considerable amount of debt issued between 25 and 27, a period marked by peak pricing, lax underwriting and high-leverage loans, will mature this year. Rising distress, however, may not translate into a flood of deeply discounted, high-quality REO office deals. Banks will likely continue to opt for loan modifications and extensions when possible, avoiding additional near-term foreclosure-related losses. Overall, more REO activity will occur, but the growing number of opportunistic investors laying in wait diminishes the likelihood that price discounting for quality assets will approach levels reminiscent of the RTC days. 21 Capital Markets Outlook Long-Term Rates Remain Low. The 1-year Treasury yield increased in late 29 and early 21 but remains low by historical standards. Moderate economic growth and tame inflation should prevent a major run-up in yields this year. Though not expected, a sharp rise in interest rates would pose further significant risk to commercial real estate values. All-in Rates Relatively Stable. Lenders will continue quoting all-in rates instead of spreads over Treasuries, limiting fluctuations in borrowing costs. All-in rates for new five-year mortgages currently range from 6.5 percent to 7. percent. On average, LTVs are 6 percent to 65 percent. Investors Tap Public Markets. Tight lending among traditional sources of mortgage debt will result in a growing number of IPOs this year. Many REITs will tap the stock market to pay down existing debt or raise capital for acquisitions. Seller Financing, Assumable Debt Critical. Office mortgage originations declined more than 7 percent last year and will remain at reduced levels in 21. A significant share of investors will rely on assumable and/or seller financing, which was involved in roughly half of all commercial real estate sales in Annual Report

10 Investment Outlook Investors Shifting Strategies as Opportunities Surface; Distress Deluge Fails to Materialize Following a 5 percent decline last year, investment activity is expected to accelerate in 21, but transaction volume will lag the peak levels of a few years ago. As the economy stabilizes, buyers will become more active. The trend has already begun, as sales velocity increased in the second half of 29. Investors will continue to move off the sidelines to take advantage of attractive acquisition opportunities driven by the cap rate premium over Treasuries and corporate debt. Stabilized assets will receive the greatest buyer interest, particularly properties with established tenants under long-term leases. Assets with lease rollover exposure within the next 12 to 24 months will be underwritten cautiously, as investors remain reluctant to pursue properties where the length of time required to re-lease space or the rents that can be achieved are uncertain. Opportunity funds that stockpiled capital in advance of an anticipated wave of foreclosure sales found the inventory of these assets limited, especially among high-quality properties. With banks offering modifications and extensions of up to three years on average, distressed deals may make headlines but will not account for a significant share of investment activity. Buyer motivation will shift in 21 from trying to time the market s bottom and acquire assets for pennies on the dollar to thoughtfully evaluating opportunities for the short and long terms. Cap rate trends will vary by property class and market quality; initial yields for trophy assets began to tick lower late last year as competition intensified. Outside of the best properties in top markets, cap rates will likely continue to rise as concerns surrounding re-leasing of space persist. 21 Investment Outlook Average Cap Rate Office Property Price Trends Price per Sq. Ft. Cap Rate $25 1 $2 9% $15 8% $1 7% $5 6% Office Cap Rate Trends by Market Type Primary Secondary Tertiary 1 9% 8% 7% 6% Average Cap Rate Tight Construction Financing Limits Supply-Side Pressures. Investors will benefit from diminished construction as the economy recovers. Completions in 21 will reach the lowest level in nearly 2 years, and the planning pipeline remains thin. As a result, owners of existing properties will have opportunities to fill space prior to the next upturn in construction. Investment Competition Intensifying for High-Quality Assets. Investment activity in secondary/tertiary markets and for lesser-quality assets will remain modest this year; however, buyers have already begun to aggressively pursue higher-quality properties in primary metros, a trend that will gain momentum as 21 progresses. Foreign Buyers Targeting Gateway Markets. Foreign buyers accounted for approximately 1 percent of office investment volume in 29, a figure expected to increase this year as pricing and cap rates remain attractive. Sales will center largely on top coastal markets, including Washington, D.C., New York City, Los Angeles and San Francisco. Medical Office a Buyer Favorite. Medical office assets posted comparatively stable occupancy and rents through the recession, stimulating investment demand and preventing dramatic price declines. Cap rates for MOBs have inched up an average of 1 basis points since 27, while the median price has dropped 12 percent, compared with a 25 percent fall for traditional office properties. MOBs comprised nearly half of all sales activity in many secondary and tertiary markets last year. Development Deals a Primary Source of Distress. As of the fourth quarter of 29, approximately 2 percent of construction loans were more than 3 days past due, nearly twice as high as one year earlier. Many lenders remain unwilling to offer modifications on construction loans, creating opportunities among stalled development deals. Total Transactions Percent of Total 2,4 1,8 1,2 6 Office Investment Trends Total Transactions by Price Category 1 75% 5 25% 4 $1M-$1M $1M-$2M $2M Office Investment by Buyer Type Foreign Equity Fund Institutional Private Public User/Other Annual Report page 9

11 Atlanta Down 1 Places 21 Rank: Rank: % -3% -6% -9% $24 $22 $2 $18 $16 22% 2 18% 16% 14% Oversupply, Weak Demand Dampen Near-Term Prospects; Extended Outlook Brighter Atlanta office fundamentals will weaken further this year, but occupancy and rent reductions will fall short of those in 29 as office-using employment losses slow dramatically. While a few high-rise buildings will come online mostly vacant in 21, their deliveries will empty the development pipeline, giving way to minimal construction over the next few years. Two of the four office towers slated for completion are in the Buckhead/Lenox submarket, where two high-rises also came online in 29. The area will again register a disproportionate increase in vacancy as a result, following a jump of more than 5 basis points last year. Developers already have taken massive writedowns on recently completed and under way projects in the metro, and REO/foreclosures have become more prevalent. These trends will intensify in 21, as roughly 22 percent of Atlanta office CMBS loans are on servicers watch lists, and vacancy issues will persist for several more quarters. Despite current oversupply concerns, Atlanta remains well-positioned for long-term growth, which eventually will yield heightened absorption. Even during the recession, the metro landed Sony Ericsson s North American headquarters, along with NCR s corporate relocation and its new customer service center. After declining 65 percent last year, office sales will rise modestly in 21, driven by more bank-owned property transactions. The current lull in activity is attributable to the wide buyer/seller expectations gap and significant financing constraints, particularly for deals over $15 million. Only one Class A property sold in 29, and it traded at a sizable discount from the previous sale and involved assumable debt. Metrowide, cap rates bottomed at an average of 6.5 percent for Class A assets and 8 percent for Class B/C product in 2 and 27. Initial yields have since increased 2 basis points or more, depending on property quality and location. Further correction will occur as owners who must sell adjust price and cap rate expectations to clear the market. In the near term, most deals will involve seasoned in-state buyers who can leverage existing bank relationships to obtain new loans. Institutions and foreign investors will remain largely absent, focusing instead on core markets set to lead the recovery. 21 Market Outlook 21 NOPI Rank: 31, Down 1 Places. Forecasts for continuing job losses, negative net absorption and elevated office construction drove down Atlanta 1 places in the NOPI. $18 $16 $14 $12 Employment Forecast: Employers will trim payrolls by.2 percent in 21, shedding 4, jobs. Last year, 14,5 positions were eliminated. Construction Forecast: Developers will deliver 1.8 million square feet of competitive space this year, down from 2.3 million square feet in 29. Forecast: After jumping 18 basis points last year, vacancy will rise 11 basis points to 19.5 percent in 21. Rent Forecast: This year, asking rents will dip 1.7 percent to $2.84 per square foot, while effective rents will recede 4.1 percent to $16.25 per square foot. $ Investment Forecast: Investors with cash on hand may want to consider opportunities in the Central Perimeter. This area boasts below-average vacancy and should lead a recovery due to limited construction in recent years. Market Forecast Employment:.2% Construction: 22% : 11 bps s: 1.7% page 1 21 Annual Report

12 No Change 21 Rank: Rank: 24 Austin Growing Economy to Fuel Investor Interest; Expectations Gap Remains Relatively Wide Austin led the nation in economic growth in 29, a trend that should continue this year as the venture capital markets begin to thaw, helping to support a turnaround in the local office market in late 21. In fact, the metro s largest venture investment since 27 recently transpired, signaling that pension funds and universities are willing to reinvest in small businesses. Although startups will be the catalyst for job growth, the small blocks of incubator space occupied by these companies will make only a modest dent in absorption during the first several months of the year. Operators in the Northwest submarket, in particular, will struggle to fill vacant speculative space until major office users initiate expansion plans. Although tenant interest in some of these vacant buildings has escalated in the area due to the concentration of major corporations, most office users with expiring leases are requesting and receiving substantial concessions to remain in their current spaces, keeping tenant churn relatively low. The large, contiguous blocks of space will likely begin to be absorbed later this year by companies relocating from other states to reduce business costs. The relatively light economic downturn in Austin has led to a wide disconnect between buyers and sellers. Although some owners anticipate a rebound in valuations, market realities are beginning to permeate the investment climate, which should lead to an uptick in velocity later this year as sellers lower prices. In the meantime, forced sales and off-market REO deals will make up a considerable share of transactions. In addition to distress sales, owner-user velocity will maintain momentum in 21. Local banks are providing lending for these transactions at a debt-service coverage ratio near 1.5 and requiring operators to carry their business accounts with the institution. Tenants with long-standing relationships with these regional banks are well-positioned to acquire their own buildings. -2 9% 6% 3% -3% $27 22% 2 18% 16% 14% 21 Market Outlook 21 NOPI Rank: 24, No Change. Healthy employment growth should spark demand in Austin this year, but an elevated vacancy rate kept the metro near the middle of the 21 index. Employment Forecast: After a modest downturn in the employment market last year, payrolls are anticipated to expand by 2.5 percent in 21 with the addition of 19,1 positions. Of those, 4,7 jobs are expected in office-using sectors, a 2.6 percent gain. $24 $21 $18 $15 Construction Forecast: Development will slow to 33, square feet of competitive office stock this year, a.8 percent increase to inventory. $2 Forecast: Demand growth will be outpaced by new construction, resulting in a 5 basis point rise in vacancy to 2.6 percent by yearend 21. Last year, vacancy climbed 13 basis points. Rent Forecast: Asking rents will retreat 4.1 percent this year to $24.65 per square foot, while effective rents will slide 5.9 percent to $19.75 per square foot, the lowest rate since 2. $175 $15 $125 Investment Forecast: Most traditional office deals that take place in 21 will involve older Class B assets with local tenants. Investors are targeting these properties priced below $3 million and at cap rates above 1 percent. $ Market Forecast Employment: 2.5% Construction: 34% : 5 bps s: 4.1% 21 Annual Report page 11

13 Boston Down 2 Places 21 Rank: 5 29 Rank: 3 4% 2% -2% -4% Realignment of Sellers Expectations Necessary to Unlock Boston Opportunities Despite projections for modest job growth this year, continued additions to office stock will deepen the oversupply in Boston, driving up Class A vacancy. Nearly 35, office-using positions have been eliminated in the metro through the recession, and limited business expansion will contribute to the surplus in office space. Tenant demand for new space remains tepid, and the largest development scheduled for completion in 21, Waterfront Square, was less than 3 percent pre-leased at the beginning of the year. More affordable space in close-in areas will continue to receive the greatest tenant demand as companies seek to minimize costs. Class B/C vacancy in Cambridge fell 2 basis points last year to the low-7 percent range, while lower-tier vacancy in the Back Bay/Fenway submarket declined 17 basis points to the low-13 percent range % 16% 14% 12% 1 Buyers and sellers expectations will continue to align as the year progresses, supporting increased investment activity. Many owners remain hesitant to sell at current market yields, opting to hold until valuations return to higher levels. These operators may want to consider divesting properties from their portfolios, however, as cap rates will likely rise further this year, and greater upside could be present through unlocking equity and repositioning capital in underperforming assets. In the near term, Class B properties along Route 128 from Waltham to Woburn may provide more stability due to above-average tenant demand resulting in vacancy levels above the marketwide rate and potentially more stable revenues over the next several quarters. 21 Market Outlook $4 $35 $3 $25 21 NOPI Rank: 5, Down 2 Places. Despite one of the lowest anticipated vacancy rates in the country, Boston slipped two spots in this year s ranking due to steep forecast rent and revenue declines. Employment Forecast: Approximately 22, jobs will be created in 21, a.9 percent increase. Last year, employers cut 55, workers. Office-using employment is expected to expand by 8,4 positions, or 1.3 percent, after 14,1 jobs were removed in 29. $2 Construction Forecast: Developers will complete 7, square feet of office space in 21, down from 794, square feet last year. The largest project expected to come online, the 5,-square foot Waterfront Square, is scheduled for delivery in the first quarter. Over the past five years, annual completions have averaged 76, square feet annually. $18 $16 $14 $12 $ Forecast: Rental demand will remain weak this year, contributing to a 6 basis point rise in the vacancy rate to 14.6 percent. In 29, vacancy increased 12 basis points. Rent Forecast: Asking rents will drop 5.7 percent to $33.94 per square foot in 21, and effective rents will decline 8.5 percent to $27.23 per square foot. Investment Forecast: Investment activity should pick up toward the second half of the year as the expectation gap between buyers and sellers narrows. Close-in Class B properties will likely provide greater upside opportunities due to steadier tenant demand. Market Forecast Employment:.9% Construction: 12% : 6 bps s: 5.7% page Annual Report

14 Up 2 Places 21 Rank: Rank: 18 Charlotte Builders Overshoot the Market; Additions Push Metrowide to Record Levels The recovery in the Charlotte office market will remain stalled by ongoing additions to supply and a slow pace of hiring. Indeed, while employment growth is expected to resume in 21, only a fraction of the positions lost over the past few years will be returned, sustaining tepid office space demand. Completions will soar, meanwhile, as a number of projects underwritten prior to the onset of the recession reach the market. Approximately 2.4 million square feet will come online in the CBD alone this year, including the 1.3 million-square foot Duke Energy Center. Preleasing activity of just 72 percent at the beginning of 21, however, will contribute to pushing up Class A vacancy in the Uptown submarket by about 4 basis points to the mid-8 percent range by year end. As a result of added competition amid soft tenant demand, concessions are expected to rise approximately 11 basis points to a market-high 18.2 percent of asking rents. Investment opportunities exist in Charlotte, despite near-term challenges. After reaching a low in 29, transaction velocity is expected to accelerate this year as buyer confidence grows and hiring resumes. Investors will focus on properties in core office areas south of the Uptown submarket, such as Ballantyne and South Park, due to increased demand from businesses looking for more affordable rents proximate to the CBD. Limited construction in these submarkets also supports a stable short-term outlook. Marketwide, cap rates currently average in the low- to mid-8 percent range and will tick higher through 21 as buyers underwrite for greater risk. 6% 3% -3% -6% % 16% 14% 12% 1 21 Market Outlook 21 NOPI Rank: 16, Up 2 Places. Charlotte will record strong job growth and absorption this year, fueling the metro s two-place gain in the index. $24 Employment Forecast: Roughly 8, positions will be created in Charlotte in 21, an increase of 1 percent. Last year, 35,6 jobs were lost. Office-using employment will rise 1.6 percent, or by 3,4 employees, after 8,8 workers were cut in 29. Construction Forecast: This year, approximately 2.7 million square feet of office space is slated for delivery in the metro. Builders completed 1.7 million square feet in 29. $22 $2 $18 $16 Forecast: A number of major projects will come online in 21, pushing up vacancy 22 basis points to 17.6 percent. Last year, weakness in the banking industry contributed to a 28 basis point spike in vacancy. $18 Rent Forecast: As concessions increase to 18.2 percent of asking rents this year, asking rents will drop 2.1 percent to $21.7 per square foot, and effective rents will retreat 3.5 percent to $17.23 per square foot. In 29, asking and effective rents fell 1.5 percent and 3.9 percent, respectively. Investment Forecast: Investors should consider opportunities south of the CBD. Supply additions will flood the Uptown submarket in the near term, driving vacancy higher and keeping rent growth in check. Demand for more affordable space proximate to core business areas and expectations for limited construction make south-suburban properties more attractive investments. $16 $14 $12 $ Market Forecast Employment: 1. Construction: 58% : 22 bps s: 2.1% 21 Annual Report page 13

15 Chicago Up 3 Places 21 Rank: 9 29 Rank: % 3% -3% -6% $3 22% 2 18% 16% 14% East Loop Operations Weaken; Stability in Northern Submarkets Draws Investor Interest Arising amount of available sublease space and modest demand will keep vacancy in the Chicago metro near historical highs and further pressure rents this year. The East Loop submarket will continue to have the greatest amount of sublease availability in the city as tenants relocate to more affordable areas or recently completed space. Kirkland & Ellis LLP, Aon Corp. and Unilever all left large blocks of sublease space when they moved out of the submarket last year, driving up vacancy nearly 2 basis points. As a result, rent declines in the East Loop will be the steepest in the city this year, which will drag down area property values and hinder deal flow. Conversely, properties in the North Michigan Avenue submarket will outperform in 21 due to the area s high concentration of medical and education tenants. Employment in these sectors will continue to grow at the highest rate of any local job segment, generating steady demand and relatively healthy office conditions in this submarket. The number of smaller lease agreements continues to increase in the suburbs, but absorption levels will not be sufficient enough to strengthen fundamentals. After 29, square feet came online in the suburbs last year, completions will accelerate in 21, pressuring operations. Despite healthy pre-leasing activity, most of the new space will be occupied by relocating tenants, resulting in additional occupancy and rent declines in existing assets, particularly in the Northwest and Southwest submarkets. Investors with a penchant for improving vacancy rates may find discounted opportunities in these areas. Buyers seeking relative safety will target properties in the North submarket and along the East-West Corridor, which was the only suburban area to post positive absorption last year, a trend expected to continue through 21. The North submarket, which includes the cities of Northbrook and Deerfield, will be the first to recover, however, due to its diverse product mix and access to transportation corridors and downtown employment hubs. $27 $24 $21 $18 21 Market Outlook 21 NOPI Rank: 9, Up 3 Places. Minimal new construction should limit the vacancy rise in Chicago, driving up the metro three spots in the NOPI. Employment Forecast: Following the loss of 181, jobs last year, employers will generate 32, new positions in 21, a.7 percent increase. Office-using payrolls will expand by 2.1 percent, or 22,6 workers. Construction Forecast: Developers are on pace to complete 54, square feet of office space this year, all of which is located in the suburbs. $16 $14 $12 $1 $ Forecast: Weak demand in suburban areas will drive a 4 basis point rise in metrowide vacancy to 18.6 percent in 21. Last year, the rate spiked 19 basis points. Rent Forecast: Asking rents will end the year at $26.62 per square foot, while effective rents will retreat to $2.34 per square foot, annual decreases of 2.6 percent and 4.6 percent, respectively. Investment Forecast: Owners continue to adjust to market conditions by lowering prices. Initial yields in the city will average in the mid-8 percent range in 21, while first-year returns for suburban assets will reach the high-9 percent to 12 percent range, depending on tenant roster and location. Market Forecast Employment:.7% Construction: 87% : 4 bps s: 2.6% page Annual Report