US Real Estate Market Outlook 2012

Asset management Real estate research & strategy Not for Retail Clients US Real Estate Market Outlook 2012 UBS Global Asset Management, Real Estate Research & Strategy - US William Hughes, Tiffany Gherlone, Amy Holmes, Kim House, James McCandless, Brian O’Connell, Ram Odedra, Matthew Reisner & Laurie Tillinghast Dear Reader, UBS Real Estate Research & Strategy once again offers a US market perspective in our US Real Estate Market Outlook 2012. This report presents a collection of economic, capital markets and real estate related data, accompanied by the collective interpretation of the Strategy Team. The objective is to provide a general strategic framework from which portfolio managers can build specific plans to meet individual goals. The included opinions were formed by evaluating the general economic and capital conditions of the nation and the collective market conditions of 65 metropolitan areas, shown below. Our economic outlook has changed little over the past two years. Following the severe recession ending 2009, we have worked with the expectation that the overall economy will follow a bumpy and slow path with a positive trend. The recent path has certainly been bumpy, but the positive trend holds true. Our current expectation is that this pattern will continue as the environment stabilizes. One of the most interesting suggestions might be the idea that US commercial real estate is inexpensive on a relative basis. Early in 2011, some people, who watched core cap rates decline, made the claim that core assets were overpriced. Mid-year, we offered a report saying that the uncertainty in the market led investors to more conservative investments and that we believed the market was pricing risk correctly. In the Capital Markets section of this report, we compare the falling initial real estate yields to Treasury rates and discover that premiums are as high today as two years ago. UBS Global Real Estate has USD 62.2 billion under management with direct property investments in Continental Europe, Japan, the UK and US and in publicly traded real estate securities worldwide. The firm’s global experience in real estate securities management, private real estate investment, commercial mortgage financing and securitization, and risk management is invaluable to our market understanding. Within Global Real Estate – US, our experience includes 33 years managing private equity real estate. The firm has acquired more than 825 assets and sold more than 430. US AUM exceeded USD 18 billion (as of December 31, 2011). US Real Estate Market Outlook 2012 is a UBS Strategy Team product. Participants from acquisitions, asset management, portfolio management, client service and Senior Management contribute to the strategy development. Research & Strategy accepts the responsibility for presenting the views of the entire team. Sincerely, William T. Hughes, Jr. Global Head of Real Estate Research & Strategy UBS Global Asset Management william.hughes@ubs.com NCREIF regions West Midwest South East 65 property markets indicated by CBSA or division boundary Contents Page Performance scenarios 1 Economy 2 Capital markets 7 Property sector outlook Apartment 9 Hotel 11 Industrial 13 Office 15 Retail 17 Farmland 19 Strategy 21 Performance scenarios As in previous annual Outlooks, we established a set of possible scenarios for the coming year. The majority of this report is built around the expectations established in the Base Case, as shown in exhibit 1. The alternative cases, Rebound and Recession, do not set the outer limits of possible results but rather acknowledge that there is a real probability that the market will follow a different path. Each scenario case represents a set of expectations which work in concert. The objective of offering these scenarios is to establish a consistent frame of reference for considering future investments. Keep in mind that there is a limitless combination of numbers across these few variables, so we focus on the direction more than the absolute figure. Despite the fact that we underestimated the 2011 cap rate decline, we continue to hold a similar outlook for positive performance at a decelerating rate. Base Case • A survey description of the current economic conditions follows in the next section. This material is intended to be consistent with the Base Case, as shown in the exhibit 1. • In general economic terms, we expect a continuation of the modest expansion established over the past two years. Looking strictly at the numbers, we might anticipate better performance, but consideration must be given to the current behavioral state. • Risk of events that might derail the economy is significant in magnitude but shows decreasing probability. Although the likelihood of disaster is fading, recent experience of the pain associated with the credit crisis is causing investors and individuals to restrain market activity. • At the real estate level, we anticipate that income growth will increase slowly and cap rates will continue a very modest decline. • Our expectations are that there will be a slight decrease in the income return and more typical appreciation (5.9 % and 2.7% respectively), resulting in an 8.6% total return. Exhibit 1 - Performance scenarios 2012 forecasts 2011 Rebound Base Case Recession 1.6 GDP (%) 4.0 2.9 (0.05) 1.6 Employment (millions of jobs per year) 2.3 1.8 (1.0) 3.4 Inflation (%) 2.2 2.0 0.5 7.0 Retail sales (%) 5.5 4.0 0.0 0.8 NOI growth (%) 4.0 1.0 (3.0) (40.0) Cap rate change (bps) (10.0) (10.0) 20.0 6.1 Income return (%) 5.9 5.9 6.0 7.8 Appreciation (%) 5.8 2.7 (6.0) 14.3 Total return (%) 11.7 8.6 0.0 Source: UBS Global Asset Management, Real Estate Research & Strategy based on data obtained from NCREIF, Moody’s Analytics and Real Capital Analytics as of December 2011. Economic series are expressed as fourth-quarter over fourth-quarter rates of change. Alternative cases • The Rebound and Recession cases suggest consistent results that may follow if unanticipated events are averted or revealed. • If Congress offered a complete solution to deal with pending budget deficits, regardless of the drag expected by such actions, the resulting confidence could possibly lead to an unexpected rebound. • If the European nations collectively fell into an unanticipated deep recession, the contagion could derail the building strength in the US and cause a new recession. • These are two extremes of the many possible directions the general economy may take. Some solace lies in the fact that global economic variables all respond to changes, often offsetting the effects of external shocks. The figures in our scenarios change in a manner consistent with these offsetting effects. X Economy Two very different types of forces are vying to shape the US economic outlook: support from fiscal and monetary stimulus and imbalance from external shocks. The economy has been slowly gaining strength in response to fiscal and monetary policy tools. A formidable series of external shocks has, so far, prevented the recovery from evolving into a stronger, more secure, self-sustaining expansion. • A broad range of Federal stimulus programs, tax cuts and emergency unemployment benefits have been instrumental in supporting the economy since the onset of the recession. • The Federal Reserve Board provided essential liquidity to stabilize financial markets, drove interest rates sharply lower and pledged to keep rates low as long as necessary to support the recovery. • A series of external shocks, though temporary, took a toll on economic growth. These shocks included a sharp run-up in commodity prices and the natural disaster in Japan that played havoc with global trade flows. • A more serious type of shock was triggered by growing concerns that the political leadership in Europe and the United States may not be capable of addressing fiscal imbalances. Imbalances, which had been growing steadily over time, reached crisis proportions fueled by the cost of combating a global recession. For the US economy, the Base Case scenario assumes that fundamental improvement in the underlying economic sectors is sufficient to offset a minor slowdown in European growth. Policy makers in Washington and abroad must strike a balance that imposes sufficient fiscal austerity to calm global investors and still provide sufficient support to vulnerable economies. The net result is that economic growth should continue to strengthen gradually over the four quarters of 2012. However, risk-averse firms are unlikely to commit the resources required for a stronger, more secure, US expansion until they get a better sense of how some of the major risks facing the global economy are going to play out in 2012. Economic growth profile • An improving job outlook, strengthening financial conditions and continuing support from low interest rates should provide for modest strengthening in Gross Domestic Product (GDP) growth in 2012. • The expansion will remain extremely vulnerable to external shocks, especially the outcome of the evolving fiscal problems in Europe and the US. • In 2012, consumer spending, which accounts for about two-thirds of the US economy, is likely to show a slight improvement over 2011’s 2.2% annual average increase. • Although consumers will continue to be cautious, an improved job outlook should support a third year of consumer growth in 2012. • Non-residential investment spending growth may slow marginally. While growth in non-residential structures should accelerate again in 2012, equipment spending may slow as firms adjust to new hiring. • After declining for six years, residential investment is likely to be a major source of growth. • Some inventory rebuilding is expected to offset continued contraction in government spending as pressure to reduce the US budget deficit intensifies. • The decline in the value of the US dollar should support somewhat stronger export growth in 2012. • The European downturn will likely reduce demand for US exports, but should not derail US GDP growth as larger trading partners may offset the weakness in European demand. • Exhibit 2 illustrates how the USD 240 billion in 2010 US merchandise exports were distributed globally, with more than 80% sold to countries outside of the European Union. Exhibit 2 - 2010 US merchandise exports by region % 15 19 European Union Pacific Rim South & Central America North America Other 30 26 11 Source: Moody’s Analytics as of December 2011 Job market • With construction employment no longer a drag on job growth, and some momentum in manufacturing, trade and transportation hiring, the job outlook shows signs of improvement with monthly payroll employment increases averaging: 78,000 per month in 2010 131,000 per month in the first half of 2011 142,000 per month in second half of 2011 • Initial claims for unemployment, the timeliest gauge of labor market health, also point to a better job market in 2012. 2 ... - --nqh--