U.S.

Economic Expansion Prevailing Over Crosscurrents, A Few Hurdles Remain

The U.S. economy notched meaningful gains throughout an eventful 2011, enduring strong political crosscurrents and intermittent headwinds in global capital markets and job growth, as well as in consumer and investor sentiment. The modest economic recovery advanced to cautious expansion, spurred by the low federal funds rate and inationary pressure that remains in check. One sector that has signicantly impaired the onset of the recovery, residential investment, nally turned positive by mid-year U.S. Home Sales vs. Median Home Price 2011, generating a 3.5 percent annualized growth rate Home Sales Median Home Price by year end. The single-family housing market has bot7 $260 tomed, new home inventories and mortgage rates sit at Homebuyer historic lows, and existing homes sales stand 35 percent Tax Credit 6 $220 higher than the trough in mid-2010. The resumption of new residential construction and home improvements will gradually add to GDP growth in the coming year. 5 $180 Business spending, however, waned in the nal months of 2011, with signicant deceleration noted in nonresi4 $140 dential xed structures and software and equipment. This follows a trend common to early recovery sectors 3 $100 transitioning to a sustainable expansion. In addition, 00 01 02 03 04 05 06 07 08 09 10 11 12* some business investment decisions may be deferred un* Through January Sources: Marcus & Millichap Research Services, National Association of Realtors til the conclusion of the political elections, which will signicantly aect pending nancial and regulatory reforms.
Annualized Home Sales (millions)

Early reports this year exemplify the continuation of mixed, but generally upbeat readings for many closely watched sectors, including manufacturing activity, consumer spending and housing. The positives now outweigh the negatives across most metrics and underscore the resiliency of the economy, but its probably too soon for all indicators to re in unison. On balance, stronger productivity and private-sector employment gains have given rise to a big turnaround in consumer sentiment, particularly for future expectations, which soared to 88 from 50 in just four months, while rst-time unemployment claims ebbed to a four-year low. Both indicators often signal higher levels of employment growth, a correlation supported by successive months of stronger private-sector job gains. Expanding Production Capacity Signals Stronger Job Creation. U.S. corporate prots per private employee reached a record high in 2011. U.S. companies have become highly productive and protable, as evidenced by record corporate prots, the cash retained on balance sheets, cumulative investment in capital equipment and software, and rising share buybacks. Current-production cash ow, which measures net corporate funds available for investment, increased by $86.2 billion in the second quarter of 2011, followed by a third-quarter increase of $35.8 billion. Third-quarter growth marks a 2.0 percent quarterly change and an annualized 9.4 percent addition to current cash ow of $1.85 trillion, the highest on record. Investment in private, nonfarm inventories and personal consumption expenditures rallied fourth-quarter GDP. Upward revisions resulted in fourth-quarter GDP recording 3 percent growth, signicantly surpassing the third quarters gain of 1.8 percent. The change in private, non-farm inventories and personal consumption expenditures, primarily in durable goods, demonstrates increased business and consumer condence in the economy. Commodity prices eased, benetting more retail segments. Total retail sales increased 6.8 percent in December on an annualized basis, benetting from strength in motor vehicle sales, up 10.9 percent. The recent easing in some commodity prices contributed to purchases across broader retail lines, particularly apparel and home furnishings. In addition, online retail sales increased an annualized 15.5 percent. A continued surge in oil prices, however, could curtail stronger economic growth.
For more information, contact John Chang, Vice President, Research Services, at john.chang@marcusmillichap.com. Marcus & Millichap 2012

Median Home Price

 Sustained employment growth underscores traction in the economy. The private sector added 1.8 million jobs measured on an annualized basis as of December, 2011, gaining momentum into 2012, with February marking the third consecutive month of job gains exceeding 200,000. The recent agreement to extend the payroll tax cut through 2012 likely contributed to improved business sentiment. The business and professional services, leisure and hospitality, healthcare, and manufacturing sectors led employment gains. In perspective, about one-third of the 8.7 million jobs lost in the Great Recession have been restored to the U.S. labor market. Forecast:

U.S. GDP Growth

GDP is forecast to average 2.2 percent growth in 2012, while payrolls are forecast to expand by another 2.2 million jobs, reducing the unemployment rate to 8.2 percent. Employment growth may trend at subpar levels until GDP moves beyond its historical average of 2.5 percent. More clarity from political elections and regulatory reform legislation will encourage a shift from temporary employment to permanent hires. The U.S. is not entirely out of the woods yet, however. Structural issues in both the housing sector and labor market will dampen recovery strength; the prospect of rising oil prices and a global nancial disruption also present risks.
Annualized Quarterly Chg. in GDP 10% 5% 0% -5% -10% 2006 2007 2008 2009 2010 2011 2012*

* Forecast Sources: Marcus & Millichap Research Services, BEA

The residential sector remains vulnerable, but sales of existing homes have returned to the long term average. Single-family home sales approached an annualized 4.1 million units in January, 2012, resulting in a 22 percent decline in inventory. Notwithstanding record low mortgage rates, low appraisal values and denied mortgage applications sent contract cancellation rates soaring to 33 percent in the fourth quarter of 2011. The median sale price declined 2.5 percent to $163,900, depressed by foreclosure activity. The end of the moratorium on foreclosures may induce a new wave of foreclosures. Consumer spending trends up on improved nancial health and stronger job and wage growth. Consumers have regained traction in their nances and exhibited a willingness to spend. Household debt-service payments as a percentage of disposable income has fallen sharply from its 2008 peak to the current 11.25 percent. In addition, record-high spikes in delinquency rates in 2009 on credit cards and all consumer loans have declined to levels lower than the average rate of the last two decades. Private-sector wages rose 5.3 percent in 2011, while personal consumption overall rose 4.7 percent. Global inuences may lower export growth and earnings for some U.S. companies. Cyclical weakness in the European economy, uncertainty about eurozone sovereign debt repayments, together with mounting tensions in the Middle East suggests slower trade growth and a possible spike in oil prices. Surging oil prices have preceded recessions since 1973, but the spike one year ago did not lead to a double-dip recession. More recent energy price ination resulted from global growth and alarm about potential supply disruptions arising from geopolitical events in the Middle East. The outlook assumes the U.S. weathers ongoing geopolitical risks with mounting job growth, consumer condence and aggressive Fed stimulus if necessary. Consumer spending and business expenditures will boost employment and stimulate demand, from which commercial real estate will benet commensurately. Unemployment rates have moved lower in 48 states and, aside from pockets of weakness that remain, a more broad-based recovery in space market fundamentals across all property sectors is underway.

For more information, contact John Chang, Vice President, Research Services, at john.chang@marcusmillichap.com.

Marcus & Millichap 2012

National Apartment Vacancy Plummets, Dees Fourth-Quarter Seasonal Slowdown

Apartment demand surges, completions sink to new Apartment Absorption vs. Homeownership lows, and a sweeping recovery matures into an expanNet Absorption Homeownership Rate sion cycle. A string of positive economic news, bene70% 100 cial shifts in demographic trends, and societal patterns continue to synchronize and thereby sustain a thriving 68% 50 rental market. The closing months of 2011 manifested meaningful increases in productivity, monthly job cre66% 0 ation, wage and income growth, consumer condence, and household formations, forming a powerful alliance 64% -50 of demand drivers. The dearth of apartment supply and continuous retreat from homeownership subsidized 62% -100 00 01 02 03 04 05 06 07 08 09 10 11 apartment performance as well. The apartment sector has fully moved into an expansion cycle as dened by Sources: Marcus & Millichap Research Services, Reis, U.S. Census a broad-based recovery in vacancy rates, rising rents, downward migration by residents to less-expensive units, improved operations for Class B and C properties, and the start of a new construction cycle.
Units Absorbed (thousands)

Vacancy rates tighten across markets and asset classes, moving the sector into expansion. The fourth-quarter vacancy rate measured 5.2 percent, representing a 40-basis-point decline from the third quarter and a sharp drop of 140 basis points from just one year ago. Historically, seasonal factors such as inclement weather, the holidays, and low turnover rates temper apartment leasing activity in the fourth quarter of the year. However, since 2009, fourthquarter absorption levels have exceeded most other quarters. The past year was no exception, as the 48,000 units absorbed in the closing months of 2011 represented the strongest quarterly gain of the year. Net absorption totaling nearly 171,000 units swamped 38,000 new units added to inventory in 2011. Eective rents grew 4 percent across the U.S., but gateway and supply constrained markets achieved double-digit increases for the second year. Aggressive rent increases more recently resulted in mild revenue loss in a few markets, which will quickly correct, but most markets continue to record steady rent growth. As a result, eective rents now meet or exceed their prior 2008 peaks in many markets. Improvement in Class A operations last year ltered to Class B properties, which in turn have progressed to a point that positions Class C properties for stronger revenue growth over the next year. Foreclosed homes and government-sponsored REO-to-Rental program oer rental housing alternatives to apartments. Depending on the location and quality of the assets, this trend could compete with apartments on a cost basis if rents should continue to climb and roommate scenarios reemerge. The national homeownership rate lost another 50 basis points over the past year, declining to 66 percent and contributing to a commensurate increase of 1,350,000 renter households, many of whom moved into rental homes rather than apartments. Sales of existing single-family homes has recovered to the 30-year annual average of 3.8 million units. However, despite record-low mortgage rates and home prices, issues of price instability, down-payment hurdles, low appraisals and credit application declines, and a preference to stay mobile continues to sideline many prospective buyers. In fact, apartment unit turnover rates due to residents becoming rst-time homeowners has diverged from the long-term average of 25 percent by nearly half. Foreclosures and short sales account for nearly 30 percent of existing single-family sales, and investors now comprise about one-third of sales. As part of the FHFA plan to shrink the GSEs single-family portfolio, the recently initiated REO-to-Rental program will market portfolios of distressed homes in select markets to pre-qualied investors who must rent the properties for a specied number of years before selling. The intention is to keep homes o the for-sale market to avert price depreciation with distressed asset sales and unloading more inventory on the market than can be absorbed in a reasonable amount of time.
For more information, contact John Chang, Vice President, Research Services, at john.chang@marcusmillichap.com. Marcus & Millichap 2012

Homeownership Rate

Cap rate arbitrage and broadly stabilizing operations Apartment Cap Rate Trends by Class create a compelling investment thesis for opporClass A Class B/C Class A-Preferred* tunistic and value-add strategies. Total sales volume 10% for 2011 increased 39 percent above year-ago levels to $64.9 billion, dominated by sales in the $40 million8% plus and $10 million to $20 million price tiers, up 52 and 42 percent, respectively. The average overall cap rate 6% fell 70 basis points to 6.5 percent from one year ago. The three asset categories referenced here include Class 4% A-Preferred* (Class A-P), located in top-tier, preferred markets; Class A properties in all other markets; and 2% 00 01 02 03 04 05 06 07 08 09 10 11 Class B and C product in all markets. Although the Includes sales $1M+ pace of cap rate compression slowed last year, the spread Sources: Marcus & Millichap Research Services, CoStar Group, Inc., RCA in cap rates between Class A-P and other asset classes diverged to 96 basis points, their widest gap in a decade. Similarly, the spread between Class A-P and Class Apartment Cap Rate Trends by Market Type B/C properties broadened to 203 basis points from the Primary Secondary Tertiary average dierential of 110. Further, the current Class 9% A-P and Class A cap rates of 4.7 and 5.7 percent, respectively, have recompressed to the lows of the 20058% 2007 cycle, whereas Class B/C cap rates remain 117 basis points higher. Investment strategies vary by buyer 7% composition. Equity funds remain active buyers of portfolios and distressed properties; international investors 6% remain committed to coastal markets, such as Washington, D.C., and San Francisco; REITS and institutional 5% 04 05 06 07 08 09 10 11 investors prefer high-density product in 24-hour cities, Includes sales $1M+ Sources: Marcus & Millichap Research Services, CoStar Group, Inc., RCA but also expanded to Class A assets in secondary Texas and North Carolina markets. Private buyers comprised a shrinking, but still high, 42 percent of transactions in primary metros and 69 percent of sales in tertiary markets in 2011, migrating to higher risk/higher return strategies. The cap rate arbitrage between asset classes, market tiers, and spreads relative to the 10-year Treasury, along with evidence of stabilizing operations in Class B assets and improvements in Class C, create a compelling investment thesis for diligently vetted value-add strategies. Forecast: Stronger job growth and household formation will provide a steady source of new entrants to the multifamily rental market. Approximately 85,000 units that are under construction should deliver in 2012, still short of fairly conservative demand projections for 120,000 units. This dynamic will drive the national vacancy rate close to a 10-year low of 4.8 percent and push eective rent gains close to 5.0 percent. The increase in permitting, starts and deliveries, and abundance of capital for construction loans signal the start of a new development cycle. Permits increased to an annualized rate of 208,300, a 53 percent rise over last year, while starts doubled year-ago levels increased to an annualized 188,700 units. An estimated $363 billion of commercial and multifamily real estate loans will mature in 2012. Banks hold the majority, but 15 percent are held in CMBS, of which $10 billion are estimated to be apartment loans. Renancing riskier debt with higher LTVs may open opportunities for increased mezzanine lending, loan extensions or recapitalization.
*Preferred Markets: New York, Washington, D.C., Boston, San Diego, Los Angeles, Orange County, San Jose, San Francisco, Seattle
For more information, contact John Chang, Vice President, Research Services, at john.chang@marcusmillichap.com. Marcus & Millichap 2012
Average Cap Rate Average Cap Rate

Apartment Market Vital Signs

U.S. Employment Trends
4%
Year-over-Year Change

Existing Single-Family and Condo Sales

Single-Family Condo

70%
Year-over-Year Change

2%

35% 0% -35% -70%

0%

-2%

-4%

01

02

03

04

05

06

07

08

09

10

11 12*

03

04

05

06

07

08

09

10

11

12*

* Forecast Sources: Marcus & Millichap Research Services, BLS

* Through January Sources: Marcus & Millichap Research Services, National Association of Realtors

Apartment Supply and Vacancy Trends

Units Completed (thousands)

Apartment Price and Cap Rate Trends

Average Price/Unit Average Cap Rate
Average Price per Unit (thousands)

Completions
440 330 220 110 0

Vacancy Rate
10% 8% 6% 4% 2%

$120 $90 $60 $30 $0

10%
Average Cap Rate

8% 6% 4% 2%

Vacancy Rate

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12*

00

01

02

03

04

05

06

07

08

09

10

11

* Forecast Sources: Marcus & Millichap Research Services, Reis

Includes sales $1 million and greater Sources: Marcus & Millichap Research Services, CoStar Group, Inc.

4Q 2010 to 4Q 2011 Change in Apartment Vacancy

Markets by Greatest Change in Vacancy

Metro
Charlotte Houston Phoenix Atlanta Austin Dallas-Fort Worth Indianapolis Columbus Jacksonville Kansas City U.S. Metro Average Sources: Marcus & Millichap Research Services, Reis

Markets by Least Change in Vacancy

Y-O-Y Chg. (bps)
-240 -240 -240 -210 -210 -210 -200 -190 -190 -190 -140

4Q 2011
6.0% 8.4% 7.3% 7.7% 4.9% 6.3% 6.0% 7.0% 9.1% 6.1% 5.2%

Metro
San Francisco Palm Beach San Jose Louisville Washington, D.C. New Jersey Milwaukee New York Oakland-East Bay Denver U.S. Metro Average

4Q 2011
3.3% 6.6% 2.9% 4.4% 4.2% 3.9% 3.9% 2.4% 3.8% 5.4% 5.2%

Y-O-Y Chg. (bps)

-100 -90 -90 -90 -90 -80 -70 -70 -70 -10 -140

The information in this report is deemed to be reliable. Every eort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, expressed or implied, may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research Services, CoStar Group, Inc., DataQuick, Deutsche Bank, Economy.com, Federal Reserve, MBAA, NAR, Real Capital Analytics (RCA), Reis, U.S. Census Bureau.

For more information, contact John Chang, Vice President, Research Services, at john.chang@marcusmillichap.com.

Marcus & Millichap 2012