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Chicago

Commercial Real Estate Recovery to Begin Second-Half 2010 according to Jones Lang LaSalle’s U.S. National Economic and Property Outlook


CHICAGO, Nov. 18, 2009 — The initial U.S. commercial real estate recovery is likely to begin in the second-half of 2010, according to Jones Lang LaSalle’s 2010 National Economic and Property Market Forecast. The following forecast details Jones Lang LaSalle’s viewpoint on the expected health of the United States commercial real estate industry for the coming year.
 
Outlook highlights
• Leasing demand levels to bottom in fourth quarter 2009, remain stagnant in 2010
• Marketed rents will fall another 5 to 7 percent in 2010
• National office vacancy to near 20 percent by late 2010
• Investment transaction volumes set to increase up to 50 percent
• Limited cap rate compression expected in coastal markets
• Bank commercial real estate loan delinquencies to surpass 10 percent by second quarter
• Conservative CMBS rebirth in 2010
 
Economic Outlook
Driven largely by government stimulus and policy, the United States recorded a stronger-than-expected 3.5 percent annualized gross domestic product (GDP) from July through September 2009, marking the end of a year-long contraction. While the recession is over and the U.S. economy is poised to maintain expansion in the fourth quarter and into early 2010, the expected growth does not represent a self-sustaining private sector expansion. The road to economic recovery throughout 2010 will remain turbulent as many downside risks remain.
 
“Trillions of dollars in aggressive federal policy continues on many fronts,” said Ben Breslau, Americas Research head for Jones Lang LaSalle. “We expect stabilizing policy actions to continue well into 2010, and the possibility of a double-dip recession lurks in 2010 if policy measures and stimulus are withdrawn too early.”
 
The labor markets are stabilizing, but are not out of the woods yet. A weak labor market is expected through at least the end of 2010. High unemployment will prevent wages from rising, which is good news for companies’ labor costs, but not for consumer spending growth. Overall employment losses will likely continue into 2010, before bottoming by mid-2010 and paving the way for lagging real estate recovery in the second-half of 2010.
 
As the economy begins to stabilize, isolated pockets of strength will appear in markets with heavy concentrations of growth industries such as health care, education and government. Outside the financial sector, profits have risen for consecutive quarters, driven primarily by cost cutting, and the health of corporate balance sheets is strong.  Companies remain cautious, but will begin to consider investments and growth as earnings improve.
 
Commercial Property Market Implications
Commercial real estate markets across the nation already have experienced the steepest pace of declines for the majority of sectors and geographies. While 2010 will be the year a global commercial real estate recovery begins, robust, broad-based growth is not expected until 2011. The recovery will not be as synchronized as the downturn. U.S. markets and sectors will reach bottom with varied timing and recovery prospects.   Progress for many markets for all of 2010 will merely consist of a deceleration in the ongoing deterioration of fundamentals.
 
Real Estate Recovery Timeline 2010
 
Q3
2009
Q4
2009
Q1
2010
Q2
2010
Q3
2010
Q4
2010
Q1
2011
Q2
2011
Q3
2011
Q4
2011
Investment sales transaction volumes bottom
Leasing transaction volumes bottom
Cap rate expansion end (real estate risk premium)
Employment bottoms
Occupancy stabilizes, rents and values bottom
Unemployment peaks
Vacancy peaks
Occupancy begins sustainable growth
Rents and values begin modest, sustainable growth
 
National office leasing market outlook
Vacancies will continue to grow over the coming quarters as sublease space increases, vacant developments scattered around the country deliver through the first half of 2010 and companies with lease expirations seize the opportunity to right-size their occupied space.
 
The heightened levels of space options, combined with the increased pockets of distress likely to emerge over the next 12 months, will depress rents further in 2010. Nationally, landlords have already dropped marketed rents close to 10 percent on average, while increasing incentives significantly to draw tenant demand. Marketed rents will fall another 5 to 7 percent in 2010 with most of the declines realized in secondary markets. While primary markets like New York, Boston, Washington, DC and San Francisco have seen double-digit rent corrections, secondary markets have generally posted smaller declines in the 4 to 6 percent range. Rent declines in the most construction-heavy markets like Atlanta, Charlotte and Miami will approach double digits in the first half of the year.
 
Overall, marketed rents nationally will likely stabilize and bottom in the fourth quarter of 2010; however, not before settling approximately 14 to 16 percent below peaks established in 2008. Net effective rents are likely to decline through the first part of 2011 as landlord incentives, such as rent abatements, continue to rise.  Peak to trough in this cycle, net effective rents will experience an average 25 percent decline nationally.
 
Leasing demand levels in 2010 will remain stagnant until employment gains start to grow and could hold steady even when new jobs start to reappear as companies will first look to fill excess internal space.  Jones Lang LaSalle’s domestic leasing outlook calls for a bottoming of leasing activity volume in the fourth quarter of 2009, but the increasing levels of shadow space on the market are likely to curb potential occupancy growth until mid-2011 and beyond in certain markets.
 
“As a result of the prevailing 2010 market dynamics, tenants in nearly every geography and product type will continue to hold heightened leverage over landlords through the better part of 2010,” added John Sikaitis, head of office research for Jones Lang LaSalle. “For strong-credit tenants, the current marketplace presents an ideal window of opportunity to lock in long-term occupancy at significantly discounted rates. Opportunities also exist for flexible credit-worthy landlords. Landlords with strong balance sheets will find it increasingly advantageous to market their financial strength, along with building features and amenities.”
 
The national vacancy rate will break through the peak of the previous 2001-2003 down-cycle during the fourth quarter 2009, and will likely approach the 19.5 percent market in late 2010 and top out near 20 percent in 2011.
 
Regional Rental Gauge
 
In the top 10 major U.S. office markets, regional rental subtleties appear.
 
Atlanta: During 2010, Buckhead and Midtown will see the delivery of 1.6 million square feet, much of which is currently un-leased. This will cause vacancy rates in the area to increase and will exert further downward pressure on rents. Leasing activity is expected to increase over the next 12 months, yet it is unlikely that this increased demand will translate to growth as tenants continue to downsize and right-size, shedding unnecessary office space.
 
Boston: Moderate development activity underway will not create undue pressure on market fundamentals; however, sublease supply remains a concern due to smaller, but still-present employment losses. Leasing activity continues to be sluggish, but with a sense of where bottom lies, sharp rent declines will give way to more modest adjustments as the office market begins to stabilize toward the second half of 2010.
 
Chicago: Vacancy rates are expected to slow their ascent as sublease space additions subside and the construction pipeline dries in early 2010. Rental rates will continue to decline as leasing velocity remains below average, dominated by renewals and subleases. Demand will return in pockets, initiated by deals offered by sublessors and well-capitalized landlords.
 
Dallas: A modest construction pipeline of 1.9 million square feet, 69 percent preleased at the end of the third quarter and largely concentrated in Uptown and Richardson/Plano, is set to deliver in late 2009 and in early 2010 and should help shift absorption back into positive territory. However, the area’s late entrance into the recession has produced growing job losses, which will likely foster depressed demand levels through the first half of 2010. Rental rates will continue to experience downward pressure before stabilizing toward the latter part of 2010.
 
Denver: While there are early signs of consumer spending and a return of private money into the market, it remains to be seen how rising consumer confidence levels will affect other areas of the economy, unemployment levels and real estate. Currently, the expectation is for local employment to stabilize between the second and third quarters of 2010. However, moderate positive and negative fluctuations could continue throughout the next year. Controlled development will help keep supply in check until market conditions stabilize.
 
Houston: In 2010, continued slow demand, downward rent pressure and increasing concessions are expected. The 2009 construction pipeline of 2.6 million square feet (representing 1.7 percent of current inventory which was 39 percent preleased at the end of the third quarter) will be aggressively priced and have a negative impact on rental rates and existing inventory.
 
Los Angeles: Continued gains in the economy, coupled with large tenant rolls over the next two years, could lead to an uptick in leasing velocity, as tenants try to lock in favorable rates and attractive concession packages. However, high unemployment in the Los Angeles area could hinder future space demand and temper leasing activity during a recovery. Further declines in rent and increases in vacancy are anticipated through the first quarter of 2011.
 
San Francisco: Market conditions have stabilized enough to better align landlord and tenant expectations, but space supplies are likely to rise and rents fall moderately in the year ahead. Although tenant-favorable conditions will persist into 2011, it could be offset by an expected jump in lease expiration volumes. Sublease space remains a drag on the market and its burden will switch to the landlord’s side of the balance sheet in two to four years.
 
New York: Leasing activity will continue to be driven by renewals and tenants with near-term expirations. New demand from business expansion is not expected until the latter part of 2010 or early 2011 as employment projections remain weak. Vacancy rates have begun to stabilize, but average asking rates continue to fall. Pricing is not likely to stabilize for another six to 12 months.
 
Washington, DC: Dramatic increases in the federal budget will continue to cushion the office market and shift absorption back into positive territory in 2010. However, the continued delivery of speculative construction projects will force vacancy rates further upward and keep leverage squarely with tenants. While rental rates will face continued downward pressure through the first half of 2010, rents will stabilize in the third quarter of 2010 due to pent-up federal demand soaking up large blocks of vacancy in the market.
 
Capital markets: Liquidity: where, and when?
The financial markets are recovering much quicker than the real economy, based on improving confidence that appears contrary to current underlying fundamental economic conditions. Jones Lang LaSalle’s 2010 national capital markets outlook calls for transaction volume increases of 30 to 50 percent, pricing stabilization and the beginnings of some limited cap rate compression in top tier coastal markets such as Washington, DC, New York and San Francisco.
 
Mounting maturities and stalled foreclosures: Despite the increasing number of troubled mortgages, relatively few large income-producing properties have been taken back by banks or involved in forced sales. Banks remain prone to extend loans for short periods in the hopes that market fundamentals will measurably improve over the course of the next two or three years.  The Office of the Comptroller of the Currency, the FDIC and the Federal Reserve seem to support the limiting or prevention of further declines in commercial real estate asset prices. These actions could stall a meaningful real estate recovery.
 
CMBS rebirth: CMBS is likely to return in 2010, but in a smaller, more conservatively underwritten form. Goldman Sachs may have re-started the market on November 16 with the first new issue CMBS deal since June 2008.  The $400 million offering was backed by 28 retail properties owned by Developers Diversified Realty. In this transaction, strong investor interest drove down spreads and showed how the overall real estate debt markets are moving gradually toward improving trading conditions.
 
Banks buckle from real estate exposure: The number of bank failures across the country in 2009 reached 123 last week, the highest level since the commercial real estate-led savings & loan (S&L) crisis in the early 1990s.  An additional 500 institutions may be at risk of failing through 2011, many due to excessive exposure to poorly-underwritten commercial real estate and construction loans. A total of 745 institutions failed from 1989 to 1994 under the Resolution Trust Corporation, an entity created to resolve insolvent S&Ls.
 
Pricing correction continues: The investment sales market reached a bottom in transaction number and value of properties traded during the first half of 2009.  For 2010, transaction volume may increase by 30 to 50 percent above 2008 levels, excluding any entity-level transaction activity that might materialize.
 
The most worrisome problem facing the commercial real estate market continues to be the $1.4 trillion in commercial mortgages held by U.S. banks that are scheduled to mature between 2010 and 2013. Bank commercial real estate loan delinquencies seem destined to surpass 10 percent by the second quarter of 2010.  In order for the capital markets to truly recover, liquidity needs to return and the commercial mortgage-backed securities market needs to re-emerge. Several mitigating factors will affect the capital markets recovery in 2010:
 
“Cap rates have increased by at least 250 basis points from the peak of the market in early-mid 2007; however, most indices still lag this correction by up to six to 12 months. Downward pressure on values could sustain for three more quarters until rental rates reach a broad level of stabilization,” said Josh Gelormini, head of Capital Markets Research for Jones Lang LaSalle. “Eventual peak-to-trough average office value declines in this real estate downturn are expected to reach the 45 to 50 percent range by the summer of 2010.”
 
Sector Outlook
 
Recovery outcomes among commercial real estate sectors vary.
 
Hotels: In 2010, hotel investors and operators across the United States will anxiously await an indication that hotel fundamentals have hit bottom. Following sweeping declines in 2009, revenue per available room (RevPAR) declines will decelerate greatly during 2010. As a whole, RevPAR in 2010 is still forecast to be down on 2009 levels, but RevPAR is expected to flatten out and record positive growth in year-over-year comparisons by mid-2010. After two to three consecutive months of flat or rising RevPAR, a consensus will likely form in the investment community that the market bottom has been hit. Recovery in the hotel sector is typically led by rebounding demand levels, which eventually lead to compression in average daily rates at hotel properties. U.S. lodging demand is expected to rise by 1.1 percent in 2010, representing the first annual increase since 2007. Due to the nightly nature of leases in the sector, hotels may be poised to kick-start the beginning stages of recovery sooner than other commercial real estate asset classes. The latter part of 2010 will mark the start of a new lodging cycle, a period when the investment community will start to transition from the year of realization (2009) to the year of increasing opportunities. While 2010 is expected to represent another difficult year for hotel transactions due to a continued scarcity of liquidity, particularly in the debt markets, deal volumes across the United States are forecast to rise from their cyclical low in 2009.
 
Retail: Two consecutive months of declines in consumer confidence reflect the continued concern consumers have for employment prospects. Unemployment is expected to peak at a quarterly average of 10.7 percent in 2010. This recession’s effects on the income and wealth of consumers may create a shift away from consumer behavior typical in previous recessions. Instead of resurgent spending on homes, vehicles and other durable goods, consumers will now prioritize debt reduction and increased savings. Notwithstanding, the retail sector has seen some modest signs of improvement. Personal consumption, largely due to the Cash for Clunkers program, rose 3.4 percent in the third quarter and made a positive contribution to the gross domestic product. Consumer spending should edge up 1.6 percent in 2010. Other moderately improved conditions include: retailers’ overall credit outlook, net absorption at 3,660,065 square feet, and a 36 percent increase in sales of retail properties over the previous quarter. The highest quality centers are poised to maintain occupancy and outperform as retailers trade up from lower quality space to centers that were once unattainable. Temporary employment also increased for the third consecutive month with a surge of 34,000 jobs. Combined with recent improvements in the Conference Board’s Employment Trends Index, this data may signify an improvement in employment conditions by mid-2010.
 
Industrial: Although leading indicators like manufacturing and retail spending appear to be picking back up, international trade and consumer confidence are still lagging. It will take several quarters for broad improvement in the U.S. economy to translate into net new demand for industrial real estate. Vacancy in the U.S. for investor-owned industrial product topped 13.5 percent in the third quarter 2009. Lack of demand in gateway and industrial distribution markets persists in areas like Los Angeles, the Inland Empire and Chicago. The rate of contraction in property market indicators will continue to moderate throughout 2010, though any recovery profile is not anticipated to be sharp.  Competition for those tenants active in the market is expected to remain intense, with concessions offering a mix of free rent and tenant improvement packages.
 
Multifamily/Apartments: In the third quarter 2009, the U.S. apartment sector vacancy rate rose to 7.8 percent, up 160 basis points from one year ago. The sector is challenged by a weak labor market, a large inventory of ‘shadow market’ rental units and various federal policies designed to stabilize the housing market and place a floor under home prices.  Such housing market assistance, while well-intentioned, typically detracts from apartment unit demand.  Landlords are aggressively lowering asking rents to lure tenants in the door which has been uncommon during past recessions. Maintaining occupancy at the expense of rental cuts is the trade-off landlords are willing to make during this recession. Net absorption totaled more than 10,000 units while 21,000 new units came online. Job growth, the largest driver of apartment demand, is not expected to resume until mid-2010, which is the earliest the sector will see demand increases.  Given the short lease lengths for apartments, landlords in this sector will be among the first to benefit as employment begins to recover.
 
Corporate occupier outlook: a renewed focus on sustainability:  Owners across the board— corporations, institutional investors and government entities— continue to seek ways to make their buildings more energy-efficient and environmentally sustainable. A recent survey by Jones Lang LaSalle and CoreNet Global confirmed that 89 percent of companies consider sustainability in their location decisions, and 70 percent said sustainability is a critical issue. At the same time, owners are extremely cost-conscious. Three-quarters of companies will invest in energy improvements in buildings they own, but 63 percent will not pay a rent premium for green space that is not offset by lower operating costs.
 
The minority of tenants willing to pay extra for green space generally expect the incremental cost to be less than 5 percent. Nevertheless, the competitive leasing market is driving owners of multi-tenant buildings to seek sustainability credentials. In the Jones Lang LaSalle/CoreNet Global survey, 90 percent of companies consider energy labels and 89 percent consider sustainability certifications in making leasing decisions.
 
Whereas in the past most Leadership in Energy and Environmental Design (LEED) certified buildings were new construction, in the past two years the number of LEED certified existing buildings has quadrupled to at least 380, and an additional 250 existing properties are registered for certification in 2010 and beyond. Participation in the U.S. EPA’s ENERGY STAR benchmarking program for buildings also continues to skyrocket.
 
To hear more details from the Jones Lang LaSalle research team quoted in this release, please listen to the audio replay of today’s “National Economic and Property Market Outlook” media Webcast. This replay is available to all interested parties until January 30, 2010.

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About Jones Lang LaSalle
 
Jones Lang LaSalle (NYSE:JLL) is a financial and professional services firm specializing in real estate. The firm offers integrated services delivered by expert teams worldwide to clients seeking increased value by owning, occupying or investing in real estate. With 2008 global revenue of $2.7 billion, Jones Lang LaSalle serves clients in 60 countries from 750 locations worldwide, including 180 corporate offices.  The firm is an industry leader in property and corporate facility management services, with a portfolio of approximately 1.4 billion square feet worldwide. LaSalle Investment Management, the company’s investment management business, is one of the world’s largest and most diverse in real estate with more than $37 billion of assets under management. For further information, please visit our Web site, www.joneslanglasalle.com.