Expectations and Market Realities 2017 Report

EXPECTATIONS & MARKET REALITIES IN REAL ESTATE
18 39
US economy expected to Thanks to growing
keep humming along in 2018 e-commerce, expect
another banner year for
industrial properties
47 54
After years of historic CRE total returns
expansion, the hotel likely to decline, but
market might slow down the overall CRE market
should remain stable
2018 ®
Expectations & Market Realities in Real Estate 2018
Stability in a Risk Environment
© 2018
Deloitte Development LLC
NATIONAL ASSOCIATION OF REALTORS®
Situs
RERC, LLC
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EXPECTATIONS & MARKET REALITIES IN REAL ESTATE 2018
STABILITY
IN A RISK
ENVIRONMENT
NATIONAL ASSOCIATION
DELOITTE OF REALTORS® SITUS RERC
SPONSORING FIRMS
DELOITTE NATIONAL ASSOCIATION SITUS RERC®
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04
EXPECTATIONS & MARKET REALITIES IN REAL ESTATE 2018 / Stability in a Risk Environment
FOREWORD
January 2018
Dear Readers,
Situs RERC, Deloitte and the National Association of

REALTORS® are delighted to present our next installment
of Expectations & Market Realities in Real Estate. In last
year’s report, we stated that global uncertainty was the new
normal. 2017 certainly did not disappoint; it was filled with
surprises and controversies — almost daily — thanks in no
small part to the political landscape, but CRE was able to
Matthew G. Kimmel, CRE, FRICS, MAI
stay above the fray and remain attractive to those looking
Principal & US Real Estate Services Leader
for stability in a risk environment.
Deloitte Transactions and Business Analytics LLP
The US economy, building on the momentum of an often

sluggish but long recovery since the Great Recession, grew
at an annual rate of about 3 percent by the end of the
year. Unemployment fell during the year even as inflation
remained low by historical standards. The Dow, the S&P and
Nasdaq soared to record levels throughout the year. Reason-
ably strong US economic growth is expected in 2018, thanks
to the corporate and individual tax cuts passed in December,
and to the Trump administration’s continued commitment to
reducing government regulations.
Due to the continued rise of e-commerce, we expect another

strong year for the industrial sector, while the retail sector
will face continued pressure to remain innovative as it faces
the challenge of online shopping. The single-family housing
market will continue to experience an affordability crisis due
to a lack of supply, resulting in a potential boost in demand
for the apartment sector.
Lawrence Yun, PhD.
In 2018, we expect that risks in the financial markets and Sr. Vice President, Chief Economist
political uncertainty will continue and keep investors on the NATIONAL ASSOCIATION OF REALTORS®
lookout for some stability. In this report, we will explore the
economy, the capital markets and the property markets in
detail and provide our collective perspectives for 2018.
We would like to extend our gratitude to all who contrib-

uted to this report. This includes the data providers, survey
respondents, economists, researchers and analysts, and
reviewers and business colleagues, without whom this report
would not have been possible. We also would like to thank
our clients, subscribers and consultants for their continued
support of this annual publication.
Kenneth P. Riggs, Jr., CFA, CRE, MAI, FRICS

President
Situs RERC
05
ACKNOWLEDGMENTS
SPONSORING FIRMS & CHAIRS
Matthew G. Kimmel, CRE, FRICS, MAI
Principal, Deloitte Transactions and Business Analytics LLP
Kenneth P. Riggs, Jr., CFA, CRE, MAI, FRICS

President of Situs RERC
Lawrence Yun, PhD Chief Economist

LEAD CONTRIBUTORS
Jodi Airhart, Director, Research and Publications
Situs RERC
Todd J. Dunlap, MAI, MRICS, Senior Manager

Kenneth W. Kapecki, CRE, FRICS, MAI, Managing Director

Andy J. Miller, Senior Manager

Jen Rasmussen, PhD, AVP, Editor-in-Chief

Situs RERC
George Ratiu, Managing Director

Morgan Westpfahl, Director

Situs RERC
ASSOCIATES
Charles Ellis, Copy Editor
Situs RERC
Janey Graveman, Graphic Designer

Situs RERC
Joseph Henry, Analyst

Situs RERC
Surabhi Kejriwal, Research Leader, Real Estate

Deloitte Support Services India Pvt. Ltd.
Matt Lamers, Senior Consultant

Saurabh Mahajan, Manager, Real Estate

Noel Nathan, Intern

Situs RERC
Neeraj Sahjwani, Senior Analyst, Real Estate

Shradha Shrestha, Associate

Situs RERC
Nellie Tiggelaar, Consultant

06
CONTENTS
1 INTRODUCTION
STABILITY IN A RISK ENVIRONMENT........................................................................................................................................................................................................................... 9

YEAR IN REVIEW: 2017......................................................................................................................................................................................................................................................... 10
THE DELOITTE DBRIEF........................................................................................................................................................................................................................................................ 11
THE CURRENT REPORT: CHAPTER SUMMARIES................................................................................................................................................................................................... 11
2 THE ECONOMY
GLOBAL PERSPECTIVES............................................................................................................................................................................................................................................................................................................................................................................................. 17
US ECONOMY................................................................................................................................................................................................................................................................................................................................................................................................................................ 18
HOUSING................................................................................................................................................................................................................................................................................................................................................................................................................................................ 20
INFLATION AND MONETARY POLICY................................................................................................................................................................................................................................................................................................................................................... 22
3 THE CAPITAL MARKETS
INTRODUCTION ........................................................................................................................................................................................................................................................................................................................................................................................................................ 25
THE FED AND INFLATION ....................................................................................................................................................................................................................................................................................................................................................................................... 26
REDUCING FINANCIAL REGULATIONS IN THE ERA OF PRESIDENT TRUMP.................................................................................................................................................................................................................... 26
TAX REFORM AND CRE .............................................................................................................................................................................................................................................................................................................................................................................................. 27
CAPITAL ORIGINATIONS ........................................................................................................................................................................................................................................................................................................................................................................................... 28
DEBT MARKETS REVIEW AND OUTLOOK .................................................................................................................................................................................................................................................................................................................................. 29
EQUITY MARKETS REVIEW AND OUTLOOK .......................................................................................................................................................................................................................................................................................................................... 31
4 THE PROPERTY MARKETS
INTRODUCTION ..................................................................................................................................................................................................................................................................................................................................................................................................................... 35
THE OFFICE MARKET .................................................................................................................................................................................................................................................................................................................................................................................................. 37
THE INDUSTRIAL MARKET................................................................................................................................................................................................................................................................................................................................................................................... 39
THE RETAIL MARKET..................................................................................................................................................................................................................................................................................................................................................................................................... 41
THE APARTMENT MARKET.................................................................................................................................................................................................................................................................................................................................................................................. 44
THE HOTEL MARKET...................................................................................................................................................................................................................................................................................................................................................................................................... 47
5 SUMMARY & OUTLOOK
INTRODUCTION ........................................................................................................................................................................................................................................................................................................................................................................................................................ 51
2018 OUTLOOK .......................................................................................................................................................................................................................................................................................................................................................................................................................... 52
ECONOMY ........................................................................................................................................................................................................................................................................................................................................................................................................................... 52
LEGISLATION ................................................................................................................................................................................................................................................................................................................................................................................................................. 52
SITUS RERC 10-YEAR TREASURY FORECAST ........................................................................................................................................................................................................................................................................................................ 52
CAPITAL MARKETS .............................................................................................................................................................................................................................................................................................................................................................................................. 53
CRE FUNDAMENTALS ..................................................................................................................................................................................................................................................................................................................................................................................... 54
SITUS RERC TOTAL RETURN FORECAST......................................................................................................................................................................................................................................................................................................................... 54
PROPERTY TYPES ................................................................................................................................................................................................................................................................................................................................................................................................. 57
FINAL CONCLUSIONS .................................................................................................................................................................................................................................................................................................................................................................................................... 57
ALTERNATIVE ECONOMIC SCENARIOS .......................................................................................................................................................................................................................................................................................................................................... 58
SPONSORING FIRMS
SITUS RERC ...................................................................................................................................................................................................................................................................................................................................................................................................................................... 59

DELOITTE ............................................................................................................................................................................................................................................................................................................................................................................................................................................. 60
NATIONAL ASSOCIATION OF REALTORS®........................................................................................................................................................................................................................................................................................................................... 61
07
1 INTRODUCTION
8
STABILITY IN A RISK ENVIRONMENT

Throughout 2017, geopolitical concerns took center stage. Possible Rus-
sian meddling in the US presidential election, serious concerns about the
possibility of a nuclear war with North Korea, deadly terrorist attacks
in the US and throughout the world, and major policy shifts on climate
control and trade agreements contributed to a heightened risk environ-
ment for investors.
President Trump also signed a number of executive orders in 2017 that

curbed regulatory enforcement for the financial industry. And while
Congress was unable to repeal and replace the Affordable Care Act, a
major campaign pledge of the Trump administration, it was able to mus-
ter enough votes to pass a sweeping overhaul of the US tax system in
December 2017 that sharply lowered tax rates for corporations and indi-
viduals. This overhaul is expected to boost short-term economic growth.
Amid the volatility, economic indicators throughout the year gradually

improved. The unemployment rate steadily decreased from 4.8 percent
to 4.1 percent, while inflation ended the year near the Federal Open Mar-
ket Committee’s (FOMC) target of 2 percent. The Federal Reserve (Fed)
increased its funds rate three times in increments of 25 basis points
(bps) to help keep the US economy from overheating without jeopardiz-
ing gross domestic product (GDP) growth, which surpassed 3 percent
by the end of the year. This adds to the stability of the commercial real
estate (CRE) market, which typically mimics (though lags) the health of
the general economy.
Despite the political chaos, investors gravitated toward the financial

markets with zeal on the hopes that tax and regulatory reform would
benefit businesses. By the beginning of 2018, the Dow soared past
26,000 and the S&P 500 and Nasdaq reached record highs at 2,800
and 7,000, respectively.
However, the bull run in the equity markets raises the risk of a stock
market correction. According to Bloomberg, the global equities market
added $2.1 trillion to the market capitalization in less than two weeks of
the new year. The US 10-year Treasury yield has moved up higher since
the tax reform bill was passed. Further rate hikes and shrinkage of the
Fed’s balance sheet will likely put more upward pressure on bond yields.
Long-term return averages, however, paint a different picture of the

financial and capital markets. Exhibit 1-A shows historical returns for
several investment alternatives. CRE returns have held their own against
stocks from a long-term perspective without having the added risk
of volatility. The 15-year annual return on the Dow and S&P 500 were
10.23 percent and 10.04 percent, respectively. The National Council of
Real Estate Investment Fiduciaries Property Index (NCREIF NPI) had
a 15-year annual return of 9.09 percent and the 15-year annual return
on the 10-year Treasury was only 3.21 percent. The significantly greater
CHAPTER 1 INTRODUCTION 9
long-term returns over the 10-year Trea- confidence, the CRE market may be begin- past the 2.0 percent target in first quarter
sury make investment in CRE as opposed ning to slow from its peak. Many experts 2017, it remained below the mark in the
to bonds worth the risk premium. While believe that fundamentals are still strong second and third quarters; core inflation
investing in one or another asset class is with low vacancy and solid rent growth spent the majority of 2017 below the 2.0
never a binary decision, CRE tends to be expected for at least the next year. Market percent target.
more favorable than other investment participants should look to take advantage
alternatives because of the relative stabil- of high prices and strategically shift their For CRE, we forecast that 2017 would con-
ity of the income component of returns. portfolio allocations to better capture tinue to offer solid risk-adjusted returns,
Moreover, investors can reap tax benefits market potential. that the CRE market would maintain its
from the CRE investment while hedging strong fundamentals and that CRE values
themselves against inflation. YEAR IN REVIEW: 2017 would continue to support prices. How-
Last year in our annual Expectations & ever, we thought that the market was fully
The expected continued stability of Market Realities in Real Estate 2017 – priced, and CRE growth would be more
CRE fundamentals further supports the Intersection of Global Change: Embrac- measured, or even flat for certain property
stability of this asset class. According to ing a New Era, we anticipated an eco- sectors. We predicted cap rates would
a survey of top CRE valuation experts nomic boost because we believed the stabilize and begin an upward trajectory,
conducted by Situs RERC in third quarter new presidential administration would but spreads would remain healthy.
2017, CRE valuations are not expected to implement more pro-business policies and
change much over the next year as 80 fewer regulations. We predicted 2017 GDP Indeed, we witnessed prices and vol-
percent said CRE values would remain the growth to remain between 2 percent and 3 ume leveling off in 2017 for the majority
same and 20 percent predicted they will percent, with inflation likely staying below of property types. In third quarter 2017,
increase, but only by 1.0 percent. Over the the Fed’s target rate of 2 percent, and the transaction volume decreased for all prop-
course of 2017, significantly more respon- US unemployment rate continuing below erty types except industrial and apart-
dents came to believe that the tremen- 5 percent. ment, according to Real Capital Analytics
dous CRE price growth witnessed over (RCA). Also based on RCA data, year-over-
the past recovery cycle would continue in Many of our 2017 expectations were real- year (YOY) price changes were negative
2018 and that the eventual correction in ized. The Bureau of Economic Analysis for retail and hotel, increased for industrial
values will be minimal. (BEA) reported that the US economy grew and apartments, but were stable for office,
at a faster clip, from 1.2 percent in first supporting our 2017 expectations. Spreads
Geopolitical uncertainty will continue to quarter 2017 to 3.0 percent in third quarter between Situs RERC required pre-tax
weigh on investors’ minds, but the focus 2017. According to the Bureau of Labor yield rates and 10-year Treasurys remained
has turned toward a number of positive Statistics (BLS), the US unemployment stable across the first three quarters of
economic indicators and the continued rate dropped during the year from 4.8 2017, between 550 and 560 bps, and the
optimism over tax reform. Despite this percent to 4.1 percent. While inflation rose cap rate for all property types was 10 bps
Exhibit 1-A
Compounded Annual Rates of Return as of 9/30/2017
1-Year 3-Year 5-Year 10-Year 15-Year

Market Indices YTD6
Trailing Trailing Trailing Trailing Trailing
Consumer Price Index1 1.10% 2.23% 1.23% 1.30% 1.68% 2.08%
10-Year Treasury Bond2 2.33% 2.27% 2.09% 2.21% 2.63% 3.21%
Dow Jones Industrial Avg.3 15.46% 25.45% 12.35% 13.57% 7.72% 10.23%
NASDAQ Composite4 21.06% 24.12% 13.19% 15.90% 9.20% 12.12%
NYSE Composite4 8.79% 15.97% 4.49% 8.15% 1.98% 6.56%
S&P 5003 14.24% 18.61% 10.81% 14.22% 7.43% 10.04%
NCREIF NPI5 5.15% 6.98% 9.93% 10.45% 6.27% 9.09%
NCREIF NFI ODCE5 4.95% 6.58% 9.52% 10.13% 6.03% 8.85%
NAREIT Index
6.04% 2.57% 10.18% 9.97% 6.06% 10.98%
(Equity REITs)3
1
B ased on published data from the Bureau of Labor Statistics (Seasonally Adjusted). sources BLS, Federal Reserve Board, S&P, Dow Jones,
2
Based on Average End-of-Day T-Bond Rates. NCREIF, NAREIT, compiled by Situs RERC, 3Q 2017
3
Based on Total Return Index, and includes the Dividend Yield.
4
Based on Price Index, and does not include the Dividend Yield.
5
NCREIF Total Return, composed of Capital and Income Returns.
6
Year-to-date (YTD) averages are current as of September 30, 2017. YTD averages are
compounded annually except for CPI.
10
higher in third quarter 2017 than it was a percent felt that values would have little
year ago. or no change.
As presented in our 2017 Expectations & About 47 percent of the respondents

Market Realities report, we forecast that believed that multifamily assets would
total expected returns for the NPI would offer the most favorable investment
be approximately 6.0 percent for institu- opportunity based on the fundamentals
tional properties on an unleveraged basis. for the property type. In comparison,
The 2017 year-end total return for the office and industrial and warehouse
NCREIF NPI was near 7.0 percent due to a assets were believed favorable by 12 per-
stronger-than-expected capital apprecia- cent and 14 percent of the respondents,
tion return in the fourth quarter. respectively.
THE 2017 YEAR-END TOTAL Compared to

2016, Dbrief
RETURN FOR THE NCREIF NPI participants
WAS 7.0 PERCENT DUE TO

predicted that
capital avail-
STRONGER-THAN-EXPECTED ability would

be the same or
CAPITAL APPRECIATION RETURN greater in 2017.
The percentage
IN THE FOURTH QUARTER. of respondents
suggesting
THE DELOITTE DBRIEF that capital would seek a riskier position
For the past six years, the authors of increased from 18.5 percent to 29 percent
this report have conducted a webinar, YOY, yet they did not believe the excess
known as Deloitte Dbrief, to showcase capital would lead to overly aggressive
the results of our report. Each year, we pricing.
polled the webinar participants to gauge
their sentiment about the market. For THE CURRENT REPORT:
the 2017 Dbrief, the number of responses CHAPTER 2 SUMMARY
for these survey questions ranged from In Chapter 2 of this report, we provide
2,360 to 3,088. See Exhibit 1-B for charts a look into the US and global economies.
of selected poll results. We discuss primary components of the
US economy, trade statistics, employment
The 2017 DBrief poll showed optimism and demographic trends, and
among participants in the state of the monetary policy.
economy and CRE. About 13 percent
of the respondents believed that the A year ago, global economies were see-
overall economy would go full speed ing potential declines, with central banks
ahead in 2017 compared to 3.7 percent resorting to negative interest rates, but
of responses in 2016. An additional 42 since the third quarter of 2017, economic
percent of the 2017 respondents believed activity has picked up around much of the
that the economy would continue grow- world. The United Kingdom’s economy
ing in a slow to modest pace, compared posted a moderate 1.7 percent gain by
to 34 percent of the respondents in 2016. third quarter 2017, nowhere near the
recession expected a year ago, per The
The highest number of respondents (33.7 Economist Intelligence Unit. Other Euro-
percent) felt that the CRE market was pean countries such as Germany, France,
in the early stages of a recovery in 2017 Italy and Switzerland posted GDP growth
and an additional 19 percent felt that a in the 1.7 percent to 2.8 percent range.
robust recovery was underway. Only 4
percent of the respondents believed that The US continued its path of expansion
the CRE market was poised for further for the eighth consecutive year. Rising
deterioration, compared to 7 percent of optimism about economic conditions
the respondents in 2016. Despite the per- fueled employment gains, and higher
ceived optimism in the CRE market, only wages, business investment and consumer
3 percent of respondents expected to spending. Payroll employment registered a
see robust strengthening in CRE values in net gain of 1.68 million new positions from
2017. The greatest number of respondents January through November, according to
(about 39 percent) expected moderate the BLS, with the private sector account-
improvements in CRE in 2017, while 36 ing for 1.62 million net new jobs.
Exhibit 1-B
Deloitte Dbrief Poll Results
Which property type do you view as offering the most favorable investment opportunity based
on recent performance of fundamentals?
Most Favorable Least Favorable
2011 2012 2013 2014 2015 2016 2017
Office 17.5 % 13.1% 12.3% 13.0% 16.0% 14.0% 11.5%
Industrial and Warehouse 11.9 % 10.0% 11.1% 12.4% 12.8% 10.4% 14.0%
Multifamily 29.2 % 45.8% 46.8% 45.5% 35.5% 40.7% 46.8%
Retail 9.4 % 8.4% 8.4% 6.5% 8.3% 7.7% 6.8%
Hotel 4.7 % 3.7% 3.2% 4.4% 6.0% 6.9% 3.8%
Not Sure 27.4 % 19.1% 18.2% 18.2% 21.4% 20.3% 17.1%
To what extent do you expect commercial real estate values to change over the next 12 months?
More stress -15% to -2% Minimal change -2% to +2%

Moderate improvemnt
improvement+2%
+2%toto
+5%
+5% Robust strengthening +5% to +15% Not sure
60
50
40
Percent
30
20
10
0
2011 2012 2013 2014 2015 2016 2017
sources The Deloitte Dbriefs Real Estate series, Expectations and Market Realities in Real Estate, March 2017
is still dealing with the large amount of With acquisition activity down, investors
Headline inflation averaged 2.1 percent 2007-era maturing debt, but that amount are finding another way to insert capital
through the entirety of 2017. Core infla- is expected to decline considerably into the sector through new construction.
tion – which excludes food and energy in 2018. Real Estate Investment Trusts (REITs), in
– averaged below 2.0 percent most of the particular, saw positive net capital flows
year, ending 2017 at 1.8 percent, according Situs RERC research shows that while largely due to capital committed to
to the BLS. institutional investors believe that the new construction.
availability of debt capital is very good,
CHAPTER 3 SUMMARY perceptions are that it is significantly Foreign investment in US CRE plummeted
In Chapter 3 of this report, we pro- below what it was a few years ago. Under- YOY, according to RCA, dropping faster
vide insight into the capital market writing standards for debt capital have than overall investment. The top coun-
environment. generally become more disciplined since tries investing in the US were Canada,
The commercial mortgage-backed securi- fourth quarter 2015 and appear to be Singapore and China, but new Chinese
ties (CMBS) lending market declined moving in tandem with the availability of regulations sharply curtailed its foreign
after the financial crisis and continued capital, suggesting stability in the market. investment. However, according to RCA,
to decline through the beginning of About $336 billion in CRE acquisitions the 2018 outlook for foreign investment is
2017 as investors sought an increase in occurred through the first three quar- encouraging, due to ongoing quantitative
yields. Fears that the new risk-retention ters of 2017, according to RCA, down easing programs in Europe and Japan.
rules would hurt the market appear to from about $355 billion during the same Chapter 3 also discusses in greater detail
have been unsubstantiated as an overall period in 2016. The decrease was most the effect of the Fed’s decision to gradu-
increase in CMBS origination was recorded notable in pricey gateway markets such ally increase interest rates and end its
in third quarter 2017. The CMBS market as Manhattan, San Francisco and Boston. quantitative easing program. In addition,
12
we discuss the impact of the 2017 tax investor interest due to the stability of The apartment market is finally begin-
reform bill, which reduces corporate and the sector. ning to show signs of slowing down after
individual tax rates. Despite all the con- a long run of dominating the other major
troversy regarding the tax bill, the effect The industrial sector has been active due property types. In the first three quarters
on CRE appears to be less than what was to growth in e-commerce and manufactur- of 2017, there was an 8.6 percent decrease
feared. Finally, 10-year Treasury rates ing. This has sparked a surge in ware- YOY for apartment transaction volume,
are projected to rise in 2018; therefore, houses, fulfillment centers and delivery based on RCA data. Considering the previ-
the spread between CRE yields and the services. Single-asset transaction volume ous seven consecutive years of growth,
10-year Treasury is expected to narrow. was weaker compared to portfolio and this decline is notable as it may signal the
entity-level transaction volume, increas- end of the cycle in this property sector,
CHAPTER 4 SUMMARY ing by only 9 percent YOY compared to which has been favored by investors for
Chapter 4 includes our highlights and 92 percent and 41 percent, respectively, many years.
expectations for the five major property according to RCA.
sections – office, industrial, retail, apart- Sales activity in the hotel sector has been
ment and hotel. Our analysis explores Sales in the retail and food service indus- booming for a number of years, but the
volume, pricing, transaction-based try are up 3.8 percent since 2016. Major historic run might be on the verge of end-
cap rates, vacancy/occupancy rates, decreases were seen in the sporting ing. US hotel construction declined YOY
absorption and completions, and rental goods, hobby, book, and music category for the first time since 2011. Hotel trans-
rates/revenues for the various (4.6 percent) and the department store action volume has slowed dramatically
property types. category (3.3 percent), according to the in five of the top six major markets even
August 2017 US Census Bureau report. though some of the smaller markets are
Although the unemployment rate was low Some of the largest mall owners and man- seeing dramatic growth. The industry is
throughout 2017, the office sector experi- agers are implementing several impres- dealing with competitive disruptions, and
enced a stark decline in sales activity dur- sive revamps, falling into two categories: the share of foreign capital investment
ing that time. According to RCA, overall entertainment-driven centers and mixed- has decreased. Nonetheless, occupancy
office transaction volume declined 19 use developments. Malls that are not able remains at an all-time high.
percent YOY in the third quarter. Central to undergo such dramatic changes are
Business District (CBD) office properties struggling, and many are closing, but our
dropped 46.4 percent YOY in the third opinion is that the shopping mall sector
quarter. The employment growth rate will not go completely extinct.
is expected to decline in 2018, but the
office sector will continue to draw a lot of
CHAPTER 5 SUMMARY office and retail because of their long- slightly above the FOMC’s 2.0
Chapter 5 looks at Situs RERC’s 10-year term locked-in leases. Nonetheless, percent target.
Treasury Forecast and the Situs RERC the overall CRE market is expected to
Total Return Forecast for the NCREIF NPI. remain stable for at least the next year. • It is most likely that consumer and
In addition, the chapter predicts future business spending will continue to
global economic growth, consumer and • Situs RERC predicts in its base case grow in 2018, thanks to higher wages,
business spending, and the prospects for scenario for the cap rate (income com- lower corporate tax rates and more
residential and commercial real estate. ponent) of NCREIF NPI returns that the consumer confidence, but so will the
slight compression of cap rates in third federal deficit.
Here are our expectations for 2018: quarter 2017 was a blip, and cap rates
• According to Situs RERC’s Treasury are expected to increase to 4.7 percent • Housing prices are expected to keep
Forecast, the 10-year Treasury rate will by the end of 2018. rising faster than wages, as demand
increase to 2.8 percent by fourth quar- continues to surpass supply, caused
ter 2018 and 3.2 percent by the end of • US GDP growth in 2018 is expected to by a shortage of qualified labor, rising
2019 for the base case scenario. be in the 2.0 percent to 3.0 percent material costs and, according to indus-
range for the base case scenario. try analysts, government policies that
• CRE total returns are expected to do not do enough to encourage
decline in 2018, driven primarily by the • Most likely, continued low unemploy- home building.
expected decrease in capital returns. ment will lead to moderate wage
This has the greatest potential to affect increases in 2018, driving inflation
14
• For CRE, many of the concerns that • Specifically, suburban office space is investors in industrial assets, especially
arose during the prolonged negotia- expected to outperform CBD from warehouses, fulfillment centers and
tions about tax reform did not come a risk-adjusted return perspective delivery services.
to pass. In 2018, there will likely be because it’s often easier to adjust
only modest changes for real suburban space to new consumer and • We can expect a slowdown in the
estate investors. employee preferences. hotel market’s historic expansion, as
foreign investment is slowing down and
• Capital is expected to be ample for CRE • The retail sector will likely remain vola- occupancy rates are leveling off; new
investment, causing prices to remain tile in 2018. Subsectors of retail, includ- supply is expected to keep pace with
high, especially for properties in Class ing high street and grocery-anchored increased demand.
A prime markets. CRE is expected to neighborhood/community centers, will
remain the best investment option com- likely perform well, yet traditional strip • The abundance of apartment con-
pared to stocks, cash and bonds amid centers and some big-box retailers struction could keep rents flat, but tax
investor fears that the stock market continue to face strong headwinds as reform might make homeownership
cannot keep soaring forever. shoppers prefer in greater numbers less attractive and therefore continue
“experiential retail” and e-commerce. the appeal of renting rather than own-
• Regarding specific property types, the ing a home.
office market is expected to remain a • The growth of e-commerce and
top investment in 2018 because of its manufacturing is expected to continue
stability, especially for foreign investors. through 2018, and that’s good news for
2THE ECONOMY
16
GLOBAL PERSPECTIVES
The global economic landscape found itself under sunnier skies during
2017. Just a year ago, developed economies were gazing into the
potential darkness of economic declines, with central banks resort-
ing to negative interest rates. Since the third quarter of last year, world
economies have rebounded and found a steady, upward path. Encour-
agingly, the economic advance is widespread, with about 75 percent
of the world economy experiencing accelerating economic activity,
according to the International Monetary Fund (IMF). In light of the first
three quarters’ activity, the IMF projects global economic growth of 3.6
percent in 2017 and 3.7 percent in 2018.
The gains were most noticeable across Europe, where the anxiety
wrought by the 2016 UK referendum decision to leave the European
Union (EU) gave way to a more tempered outlook. While the UK’s
economy posted a moderate 1.7 percent gain by the third quarter of
2017, according to The Economist’s Intelligence Unit, it was nowhere
near the recession expected a year ago. See Exhibit 2-A for a compari-
son of GDP by region.
While economic growth in the EU was broad-based, momentum gains

came mostly from peripheral countries during 2017. Based on the latest
quarterly data, the Irish economy rose by 10.5 percent, followed by
Latvia, Poland, the Czech Republic, Slovenia, and Estonia — all of which
recorded gross domestic product gains exceeding 4.0 percent, accord-
ing to The Economist’s Intelligence Unit. The other developed Eurozone
economies — Germany, France, Italy and Switzerland — displayed more
modest economic conditions, with GDP growth in the 1.7 percent to 2.8
percent range.
Asian economies continued moving with a solid upward momentum

during the year, as Chinese growth picked up a slight tailwind. While
China’s monetary policy remained accommodative, GDP increased
at a 6.8 percent annual rate in the third quarter, and was projected
to close 2017 with a 6.8 percent advance, according to The Econo-
mist’s Intelligence Unit. The Bank of Japan also continued its monetary
stimulus program, with its GDP expected to increase by 1.5 percent in
2017. India’s economy continued its growth pattern, with GDP poised
for a 6.5 percent growth rate, despite the country’s massive currency
adjustment in 2016 — the government canceled 500- and 1,000-rupee
banknotes without any advance notice. Other Asian economies —
Indonesia, Malaysia, Philippines, South Korea, Thailand and Vietnam
among them — reflected the strength of neighboring larger economies
with GDP growth in a solid range of 3.0-6.3 percent.
In the Americas, economic trends underscored a rising global tide.

Canada registered solid economic gains, with a third-quarter GDP
increase of 3.0 percent, placing the annual GDP on a path to 3.0
percent annual gain, according to The Economist’s Intelligence Unit.
CHAPTER 2 THE ECONOMY 17

Mexico’s economy took a more moder- Exhibit 2-A
ate path, with GDP projected to close 2017 Annual GDP Growth by Region
2017 with a 2.1 percent gain. During the
year, Canada and Mexico began renego-
tiating the North American Free Trade
Agreement with the US, as the President
continued to express concerns over the
benefits of existing trade agreements.
The post-Olympic glow did not last for
Brazil’s economy, which fell into a mild
recession during 2016, and experienced
a slight improvement in 2017. Argenti-
na’s economy found a more solid footing
in 2017, with GDP expected to gain 2.8
percent during the year. The econo-
mies of Colombia and Chile remained
positive, at 2.0-2.2 percent GDP rates of
growth, while Venezuela’s political crisis
deepened its economic woes.
source The Economist Intelligence Unit, January 2018
As a major engine of global economic
activity, the US continued on its path
of expansion for the eighth consecu-
tive year. As the central bank tightened Exhibit 2-B
its monetary policy, optimism about Quarterly GDP Growth in the US
economic conditions fueled employment
gains, higher wages, as well as increased
business investment and consumer
spending. The few clouds hanging in the
economic skies were a slowing housing
market momentum and continued
declines in CRE investment volume,
which provided reasons for concern
about the current real estate cycle’s
timing and duration.
US ECONOMY
Economic activity in the US accelerated
during 2017, as a strengthening labor
market boosted consumer confidence.
Corporate optimism was also elevated,
source BEA, 3Q 2017
as evidenced by market indexes and job
18
openings, which trended at record highs on. Similarly, investments in residential time frame, based on data from the BLS,
during the year. The level of economic real estate kicked 2017 off with an 11.1 with the private sector accounting for 1.62
output, however, remained moder- percent increase in the first quarter, only million net new jobs. The pace of change
ate compared with the long-term trend. to experience declines in the subsequent reflected slightly slower growth in the
In the first quarter, GDP advanced at a quarters, as large builders faced a labor third quarter. Average weekly earnings
modest 1.2 percent annual rate, according shortage and higher construction costs. of private employees increased by 2.8
to data from the BEA. However, the pace percent as of the third quarter of the year,
picked up in the ensuing two quarters, as International trade continued as a compared to one year earlier.
the GDP rose 3.1 percent in the second mainstay of economic activity, picking up
quarter and 3.0 percent in the third
quarter (see Exhibit 2-B).
The advances in economic output came

... OPTIMISM ABOUT ECONOMIC
from a combination of higher consumer CONDITIONS FUELED EMPLOYMENT
spending, increased business investments
and strong export activity. Benefiting GAINS, HIGHER WAGES, AS WELL AS
from higher wages, as well as increased
tenure for homeowners, consumers INCREASED BUSINESS INVESTMENT
opened their wallets wider for remod-
eling projects, including furniture and
AND CONSUMER SPENDING.
household appliances. With more dispos-
able income, consumers purchased more steam during the year. Exports advanced Private service-providing industries
recreational vehicles and equipment, as during the first nine months of the year continued as the employment growth
well as cars and light trucks. Consum- at a healthy clip, with US manufacturers engine, with 1.28 million net new jobs
ers also spent more on services during seeing favorable conditions in the first in the first 11 months of 2017, based on
the year, with health care, recreation and half of the year, and service providers data from the BLS. Within the service
financial services posting solid gains. adding momentum. Imports — a negative industries, benefiting from an expand-
contributor to GDP — grew more slowly ing corporate sector, the professional
Buoyed by increased demand for goods through the year, leading to an improve- and business services sector posted the
and services, along with the promise of ment in the balance of trade. highest number of net new employees
fewer regulations and lower tax rates, the — 454,000. The education and health
bullish corporate outlook was reflected in The other major GDP component — services sectors provided the second
stronger business investments. Compa- government spending — declined in each largest contribution to job growth, with
nies made capital investments through of the first three quarters, as nondefense 383,000 net new positions. With business
higher spending on information process- expenditures were scaled back. State and and leisure travel rising in tandem with
ing and industrial and transporta- local governments also cut back on infra- economic and wage gains, the leisure and
tion equipment. Businesses also spent structure investments. hospitality sectors added 235,000 net
more on intellectual property products, new employees to payrolls by November
with software investment advancing at EMPLOYMENT TRENDS 2017. As financial services added 119,000
double-digit annual rates during the first In keeping with the steady economic new positions, demand for office space
three quarters of the year. Investments in growth, employment continued expand- remained on an upward trajectory during
CRE started off the year on a high note, ing during 2017. Payroll employment the year.
with a 14.8 percent increase in the first registered a net gain of 1.68 million new
quarter, but moderated as the year wore positions over the January-November
Exhibit 2-C
Historical US Unemployment Rates
source BLS, December 2017

Demand for industrial warehouses and Exhibit 2-D
distribution centers continued apace Historical Labor Force Participation Rate
in 2017, leading to transportation and
warehousing employment gains of
72,900 new positions, with accompany-
ing employment advances in the whole-
sale trade sector of 55,800 net new jobs.
A key driver of industrial absorption came
from the expansion of e-commerce, led
by Amazon and its high-profile acquisi-
tion of Whole Foods Market in 2017, as
well as its announcement that it plans
to open a new, secondary headquarters.
On the other hand, retail stores contin-
ued struggling with oversupply, as more
department stores announced closures
and layoffs. Retail trade employment
declined by 65,800 jobs from January
through November 2017, according to the source BLS, November 2017
Bureau of Labor Statistics.
While the solid growth in service indus- Exhibit 2-E

tries outpaced employment in goods- Total Supply of Existing Homes (Months)
producing industries, the 334,000 net
new jobs was noteworthy. Construction
companies added 147,000 new positions
to their payrolls by the end of Novem-
ber 2017, based on data from the BLS. As
several large companies announced plans
to expand their existing US operations,
others scrapped plans to move plants
to other countries, and manufacturing
employment advanced by 138,000 net
new jobs. In a reversal of the past couple
of years, the mining and logging sector
also expanded, with a net gain of 49,000
new positions.
The unemployment rate fell through-

source National Association of REALTORS®, October 2017
out the year, from 4.8 percent in January
to 4.3 percent by the third quarter, and
4.1 percent in October, November and
December 2017 (see Exhibit 2-C). The to 62.4 percent in September of 2015, the HOUSING
average duration of unemployment regis- same level as in October 1977, accord- Residential real estate continued to
tered an uptick during the year, from 25 ing to the BLS. The decline slowed over grapple with an imbalance between solid
weeks in January to 26 weeks in Novem- the past three years. The LFP rate moved demand and insufficient supply in 2017,
ber of 2017, according to the BLS. The sideways in 2017 — despite monthly shifts with tight inventory for new and exist-
number of Americans employed part time — at 62.9 percent, on par with the figures ing homes. While the historical inventory
for economic reasons declined from 5.7 from a year ago (see Exhibit 2-D). As of equilibrium averages a six- to seven-
million in the first quarter to 4.8 million October of 2017, 95.4 million Americans month supply, the inventory in 2017 was
by the end of November. Echoing the were out of the labor force. about four months nationally, and even
improving trends, the average number tighter for some metropolitan areas,
of employees leaving their jobs for other The momentum in 2017 employment according to data from the National
opportunities rose to 15.6 million in 2017, found a counterpart in the consumer Association of REALTORS® (see
a 3.4 percent increase from 2016 and a confidence figures. The Conference Exhibit 2-E).
5.3 percent gain from 2015. Board’s index advanced to 125.9 by
November of the year, the highest value With an improving economy, low
The labor force participation (LFP) rate since December 2000. Separately, the unemployment and the total US popula-
has been on a downward trend for the Consumer sentiment index compiled by tion increasing by almost 9.0 percent
past 17 years; however, the rate of decline the University of Michigan rose to 97.8 over the past decade, household forma-
has slowed over the past three years. in November 2017, from 93.8 recorded tion returned toward long-term trends.
From a high of 67.1 percent during the during the same month in 2016. From 1956 to 2016, household formation
1998–2000 period, the LFP rate dropped averaged 1.2 million net new households
20
Exhibit 2-F
New Single–Family Home Sales
Sales (Thousands) of Units
source US Census Bureau, October 2017
Exhibit 2-G
Annualized Existing–Home Sales
Sales (Millions) of Units
source National Association of REALTORS®, October 2017
each year, according to the Census At the same time, faced with tighten-
Bureau. While the Great Recession ing inventory, existing-homes sales slid
curtailed that process, the past couple of from an average annual rate of 5.6 million
years marked progress, with the first nine units in the first quarter of the year, to
months of 2017 registering 1.1 million new 5.4 million units by the end of September,
households. according to the National Association of
REALTORS® (see Exhibit 2-G). Despite
Supply failed to keep up with growing continuing low mortgage rates and rising
demand as builders faced a shortage wages, the widening gap between rising
of qualified labor, rising materials costs demand and low supply led to price
and several hurricanes, which diverted appreciation outpacing wage growth. The
resources to emergency infrastructure median price of existing homes reached
projects. Monthly single-family housing $245,100 in September of 2017, a 4.2
starts averaged 826,000 units by the end percent increase YOY (see Exhibit 2-H).
of the third quarter, with completions
averaging 782,000 units, according to the Housing price appreciation has averaged
Census Bureau. New single-family home close to 6.0 percent over the past four
sales averaged a modest 608,000 units years, while gains in employment wages
during the first three quarters of 2017 increased at an annual rate slightly
(see Exhibit 2-F). above 2.0 percent. Not surprisingly, the
housing market has experienced declining

affordability. With demographic trends Exhibit 2-H
continuing to shift toward younger Median Existing–Home Prices
cohorts and supply conditions remain-
ing tight, the affordability squeeze is
expected to continue in 2018 as well,
especially for first-time buyers.
INFLATION AND
MONETARY POLICY
Confounding expectation set at the tail
end of 2016, consumer prices contin-
ued on a moderate path during 2017. The
Consumer Price Index (CPI) moved in a
narrow range most of the year, around
2.0 percent, according to the BLS (see
Exhibit 2-I). While the first quarter
recorded inflation averaging 2.5 percent,
prices moved below the 2.0 percent
mark in the May-August period. Over the source National Association of REALTORS®, October 2017
first 10 months of 2017, headline inflation
averaged 2.1 percent.
Core inflation — which excludes food and Exhibit 2-I

energy — spent most of the year below Consumer Price Index (CPI)
2.0 percent, averaging 1.9 percent over
the January-October time frame, based
on data from the BLS. The cost of housing
— both rent and owners’ equivalent rent
— comprises about a third of the CPI,
the main measure of inflation. Prices for
shelter advanced at a faster clip during
Percent
2017, averaging 3.4 percent in the first 10

months. However, the solid gain did not
push inflation much above the Fed’s 2.0
percent target.
However, given the improvement in the

employment picture and the unemploy-
ment rate nearing 4.0 percent, the
Fed moved on its promise from 2016
source BLS, December 2017
to continue scaling back its quantita-
tive easing. The FOMC voted to increase
its funds target rate three times during
2017, at its March, June and December
meetings (see Exhibit 2-J).
Exhibit 2-J
The other major change in monetary 10-Year Treasury Note Yield and Federal Funds Rate Comparison
policy came in October, when the Fed
announced the unwinding of its asset
purchases. Spurred on by the financial
crisis in the last decade and the ensuing
recession, the Fed embarked on the
unprecedented mission of propping up a
failing US economy. The goal was to inject
Percent
massive capital into the financial system,

to stabilize failing banks, and increase
liquidity so that companies and consum-
ers could borrow money at lower rates,
and revive consumption and output. The
Fed’s strategy involved purchasing securi-
ties from member banks and government
debt. In addition, due to real estate’s role
in the recession and its importance to
source Federal Reserve Board, December 2017
22
economic activity, the Fed also added a are $2.5 trillion in US Treasury securities in the Fed’s balance sheet by 50 percent
new strategy in its approach: it purchased and $1.8 trillion in MBS. Taking a broader by 2021.
long-term government notes and perspective, the Fed’s move helped the
mortgage-backed securities (MBS), while US economy grow at a steady pace since The Fed’s move to tighten monetary
simultaneously announcing that it would the end of 2009. The unemployment rate policy was further underscored by the
keep the funds rate with a lower bound of fell from 10.0 percent in October 2009 to FOMC’s December decision to increase
zero percent for an extended period. 4.1 percent in October 2017, while inflation the funds target rate by another 25
has remained under 2 percent. bps, aiming for a new range of 1.25-1.50
From an average of $900 billion in assets percent. The increase marks the third
before the recession, and through several In October 2017, the Fed announced hike in 2017, and was accompanied by the
quantitative easing projects (nicknamed that it would begin divesting its assets FOMC’s intent to continue moving the
QE1, QE2, Operation Twist, QE3, and by allowing maturing bonds to roll off rate in an upward direction in 2018.
QE4), the Fed expanded its balance its balance sheet without reinvesting the
sheet to a stratospheric $4.5 trillion as payments. The stated goal was to work
of the second quarter of 2017. The two toward a maturing bond volume of $50
major assets on its current balance sheet billion per month, leading to a decrease

3THE CAPITAL
MARKETS
24
INTRODUCTION
In 2017, the financial markets kept rising to record highs, buoyed by
positive economic indicators and hopes of broad tax reform. CRE market
returns experienced a slight downtrend in returns as expected, while an
upward trend in REIT returns continued through the third quarter of 2017.
In September, the potential for another rate hike before the end of the
year (and the Fed did raise its rate in December) drove Treasury rates
higher from the YTD lows in August. Investors continue to find value in
equities due to strong corporate earnings, but many uncertainties could
have major effects on the equity markets and CRE.
While investors still find CRE attractive, the preference for CRE relative
to other asset classes has waned over the last three years, according to
a survey conducted by Situs RERC. On a risk-adjusted basis, however,
CRE continues to be the leading investment option compared to the
alternatives of stocks, cash and bonds (as shown in Exhibit 3-A). The
preference for stocks is the lowest it has been since 2009 as investors
have become skittish about a possible market correction. Although
stocks are at new highs, there is ongoing concern that they are overval-
ued and bonds face headwinds with further tightening expected by the
Fed. Real estate carries a very low beta relative to stocks, which makes it
an attractive alternative, while its inflation-hedging features are attractive
relative to standard fixed-income investments. However, since CRE prices
have been steadily rising since the Great Recession, respondents have
generally been less likely to recommend buying CRE, given the fact we
are so late in a very long cycle.
Nevertheless, the strength of CRE continues to be evident in the spread

between CRE yields and 10-year Treasury rates, as reported by Situs
RERC (see Exhibit 3-B on page 26). Although 60 bps lower than in the
third quarter 2016, the third quarter 2017 spread remained at a healthy
5.6 percent. However, with the 10-year Treasury averaging 2.34 percent
in mid-December 2017, and forecast to rise in 2018, the expectation is
that spreads will narrow further in 2018. It is expected that cap rates for
overall CRE will flatten and begin to rise for most property types.
Despite all of the monetary stimulus, inflation remains contained. While

the Fed is likely to continue to raise rates in 2018, it is expected to do
so at a moderate and well-communicated pace. While there are signs
of a global trend of economic growth, technology, globalization and
demographics are expected to keep inflation at bay. Therefore, the rate
increases are not expected to be enough to deter CRE investment at
this juncture. Solid CRE fundamentals have resulted in historically low
CRE cap rates, despite mortgage rates being either flat or having slight
increases over the last year. Both debt and equity markets are highly
competitive in terms of originations. Specific asset and market perfor-
mance characteristics are expected to increasingly dictate the availability
of capital.
CHAPTER 3 THE CAPITAL MARKETS 25

Exhibit 3-A billion in its holdings of Treasury securities.
Situs RERC Historical Ratings of Investment Alternatives This was the biggest weekly decline since
2012. The Fed plans to gradually increase
the amount rolled off until it reaches
$20 billion a month in October 2018. The
cumulative effect of the Fed’s QE program
on CRE has been a significant increase in
the availability of capital from banks. Cur-
rently, the CRE markets are flooded with
capital and, similar to the effect of short-
term interest rate increases, as long as the
Fed’s plan to unwind the balance sheet is
clearly communicated and the withdrawal
occurs gradually, the markets are unlikely
to be hurt by the Fed’s decision.
When the Fed announced its latest rate in-

crease on December 13, 2017, it reiterated
source Situs RERC, 3Q 2017 its plan to raise rates three times in 2018
and twice in both 2019 and 2020, barring
unforeseen circumstances such as a dras-
tic jump in inflation. It is expected to make
Exhibit 3-B the banking system and insurance industry
Spread Between Commercial Real Estate Yields or Going-in Cap Rates more profitable. According to the Senate
and 10-Year Treasury Rates Banking Committee, Jerome Powell was
confirmed to replace Janet Yellen as chair-
man of the US Federal Reserve. Powell has
stated that he intends to continue the path
of gradual rate hikes set by Yellen unless
inflation rises suddenly.
Many believe that the anticipated rate

hikes will not adversely affect CRE. Mar-
ket forces have been putting downward
pressure on CRE transaction volume and
prices, and the rate hikes might acceler-
ate that pressure. Because CRE is usually
a long-term investment strategy, many
CRE owners have incorporated future rate
increases into lease agreements; as long
as the rate hikes are gradual and arrive
sources Situs RERC, Federal Reserve, 3Q 2017
as predicted, the CRE markets are not
expected to overreact.
THE FED AND INFLATION 5.0 percent while keeping inflation around
When the Great Recession began, the 2 percent. However, inflation remained REDUCING FINANCIAL
economy started shedding hundreds of stubbornly low throughout 2016 and 2017 REGULATIONS IN THE ERA
thousands of jobs a month, and the unem- and short-term interest rate hikes have OF PRESIDENT TRUMP
been small and communicated to the Since President Trump took office, he has
ployment rate soared to 10.0 percent by
markets in advance. The Fed increased its worked to eliminate or reverse numerous
October 2009. In response, the Fed even-
funds rate by 25 bps in December 2016, federal regulations, either through execu-
tually cut its fed funds rate from above 4.0
March 2017, June 2017 and December 2017, tive signing orders or congressional action.
percent to the zero to 0.25 percent range
in December 2008. The Fed also initiated and it now stands in the 1.25 percent to
1.50 percent range. During this time, infla- Perhaps the most significant change
its quantitative easing (QE) program in an
tion has remained below 2 percent and wouldn’t have happened without Vice
effort to stimulate the economy.
the national unemployment rate fell to 4.1 President Pence breaking a 50-50 tie vote
percent in October 2017 and remained 4.1 in the Senate in October. The law overturns
The key interest rate remained in the zero
percent in November and December. a Consumer Financial Protection Bureau
to 0.25 percent range until December
(CFPB) rule designed to make it easier for
2015, when it was raised to the range of
Moreover, the Fed began unwinding its consumers who believe they have been
0.25 percent to 0.5 percent as the unem-
$4.5 trillion balance sheet in October, defrauded to band together in class-action
ployment rate had fallen to 6.0 percent
which mostly contains bonds. During the lawsuits against financial institutions. The
and GDP was growing at a 2.6 percent
first week of November, the Fed’s portfolio rule had been scheduled to take effect in
annual rate. The Fed hoped to return to its
holdings showed a decline of about $6 2019. Republicans and the Treasury De-
ideal funds rate between 2.0 percent and
26
partment said the rule would have gener-

ated 3,000 additional class-action lawsuits
over the next five years, costing businesses
more than $500 million in additional legal
defense fees, $330 million in payments
to plaintiffs’ lawyers and $1.7 billion in
additional settlements. In a news release,
the Treasury Department said those costs
would primarily be passed on to consum-
ers through higher borrowing costs for
credit card users.
In November, after Richard Cordray

resigned as chairman of the agency to
run for Ohio governor, President Trump
appointed Mike Mulvaney, who already
was director of the Office of Management
and Budget, to simultaneously hold the
position of acting director of the CFPB. Le-
andra English, who had been deputy direc-
tor of the bureau, said she should properly
assume the duties as acting director, but
a US District judge ruled in December in
favor of Trump and Mulvaney.
Mulvaney has long criticized the bureau

that he is now leading. He once called the
bureau a joke “in a sick, sad way,” accord-
ing to USA Today. During his first day
on the job, Mulvaney imposed a 30-day
moratorium on new regulations, froze hir-
ing and put a temporary hold on payments
to victims of illegal banking practices. Mul-
vaney was expected to slow down or stop
impending restrictions on payday lending,
debt collection and overdraft fees.
The CFPB was established as part of the

Dodd-Frank law intended to limit some of
the excesses blamed for causing the Great
Recession. In December 2016, another
provision of Dodd-Frank went into effect:
risk-retention rules that require managers
to hold 5 percent of their Collateralized
Loan Obligation (CLO) funds. According
to Reuters, many were concerned that this
new requirement would put a damper on
issuances of CLO funds, but that did not
appear to happen in 2017.
In addition, under President Trump’s direc-

tion, the administration has in many cases
declined to enforce existing or impend-
ing federal regulations on education, the
environment, health and safety, and at the
beginning of his presidency directed fed-
eral agencies to repeal two rules for every
one they issue, according to The Hill.
TAX REFORM AND CRE

With the change in Presidential administra-
tion in January 2017, and the Republican
Party’s majority in Congress, tax reform —

which had been a major campaign promise economic growth than a cut in corporate new limitation on business interest deduc-
— contoured more precisely and picked up rates would. tions, that limitation does not apply to an
speed during the year. While both the Sen- electing “real property trade or business.”
ate and the House of Representatives put The law also exempts US corporations A business making the election out of the
forth bills outlining their respective views from US taxes on most future foreign prof- interest limitation as a “real property trade
on reform items, the legislative negotiation its; previously, they were taxed on their or business” is required to use slightly lon-
process elicited a final bill that was passed profits wherever they were earned. This ger depreciation lives for all existing and
and submitted to the President, who so-called territorial or partial exemption newly acquired real property and certain
signed it into law. system aligns the US tax code with most qualified interior improvement property.
other industrialized nations and is de-
INDIVIDUAL AND signed to reduce tax-dodging. The law sets Pass-through businesses can take a 20
CORPORATE TAX CHANGES a one-time mandatory tax of 8 percent on percent deduction for qualified business
For individuals, the act income they receive from
retained the existing seven the entity, according to the
marginal tax rate brackets, THE CRE SECTIONS OF THE Washington Post and the
but lowers the top rate from US House of Representa-
39.6 percent to 37 percent. TAX BILL LEFT MANY OF THE tives Conference Report.
The law increases the stan-
dard deduction to $12,000 PRIOR PROVISIONS MOSTLY Income for such enti-
ties pass through to the
from $6,350 for individuals,
and to $24,000 from $12,700
UNCHANGED, SUCH AS SECTION owners’ individual returns
where it is currently taxed
for married couples. 1031 LIKE-KIND EXCHANGE RULES at ordinary income tax
FOR REAL PROPERTY.

rates. In addition, the 20
Other provisions for individu- percent deduction applies
als include: to dividends paid by REITs.
• The deduction for state and local and illiquid assets and 15.5 percent on cash and There are limitations and exceptions to
income, property and sales taxes, cash equivalents for about $2.6 trillion in this deduction, but in general it will reduce
previously unlimited, was capped at US business profits now held overseas. the tax burden on owners of pass-through
$10,000. This change would affect entities and REITs and because most CRE
people who live in high-tax states, such The bill makes the business tax changes companies are structured as pass-through
as New York, New Jersey, California permanent but the cuts expire for individu- businesses or REITs, this deduction will be
and Illinois. als in 2025, returning them to the existing of great benefit to the CRE industry.
rates and setting the stage for a sharp tax
• The current Child Tax Credit of $1,000 increase for many millions of households, While the full implications of tax reform
per child was increased to $2,000 according to estimates by the Congressio- are unknown at this point, we do not
per child for families making up to nal Budget Office and the Joint Committee expect the real estate industry to be
$400,000 a year. People who don’t on Taxation. Personal income taxes would damaged by the changes. The National
earn enough to pay federal income shoot up $430 billion between 2025 and Association of REALTORS® expects the
tax can collect a credit up to $1,400 2027. Tax Act to provide short-term economic
per child. stimulus in 2018, with a possible long-term
Those most affected would be those with productivity boost assuming that compa-
• The exemption for the 35 percent incomes between $54,700 and $93,200. nies employ the tax cuts for capital invest-
estate tax, which affects fewer than Nearly two-thirds of this group would pay ments and worker training. However, given
5,000 individuals and corporations a on average $140 more than they currently that the Tax Act’s $1.5 trillion price tag
year or about 0.2 percent of Ameri- do, according to an analysis by the non- may lead to larger budget deficits, interest
cans, was doubled from $5.5 million partisan Tax Policy Center. Not only would rates may increase at a slightly faster pace.
to $11 million for individuals and $22 their tax rates return to higher levels, they
million for married couples. would also lose the increase to the stan- CAPITAL ORIGINATIONS
dard deduction and the child tax credit Situs RERC estimates the investment
However, the centerpiece of the plan is that congressional Republicans have been market for CRE in the US was $3.974 tril-
cutting the federal tax rate for corpora- touting as needed relief. lion in debt-based institutional investment
tions from 35 percent to 21 percent and properties and an estimated $3.971 trillion
eliminating the 20 percent corporate REAL ESTATE TAX CHANGES in equity-based institutional investment
alternative minimum tax. Businesses will For residential real estate, the tax act of- properties. As shown in Exhibit 3-C, key
be allowed to immediately write off, or fered a few new provisions, including a cap investors in the debt market included US-
expense, the full value of investments in on deductible mortgage debt of $750,000, chartered depository institutions (banks
new tangible personal property for five and a cap $10,000 on the deduction for and savings institutions), government-
years. The law gradually eliminates this 100 state and local property taxes and income sponsored entities (GSEs), CMBS, col-
percent expensing beginning in the sixth or sales taxes. The CRE sections of the tax lateralized debt obligations (CDOs) and
year. It also makes changes to allow more bill left many of the prior provisions mostly other asset-backed securities (ABS), life
expensing by small businesses. The con- unchanged, such as Section 1031 Like-Kind insurance companies, and foreign bank-
servative Tax Foundation estimated that Exchange rules for real property (but not ing offices among others. Equity investors
full expensing could do more to propel personal property). Although there is a included private investors, REITs, pension
28
funds, foreign investors, life insurance Exhibit 3-C

companies, commercial banks, GSEs and Commercial Real Estate Debt Universe
others as shown in Exhibit 3-D.
The Fed indicated that originations grew

roughly 5.8 percent, to $3.97 trillion, in
third quarter 2017 compared to the previ-
ous year. The US-chartered depository
institutions, which constituted roughly
51 percent of the total debt, grew 6.59
percent YOY in originations in third quarter
2017. While foreign banking offices in US
accounted for only around 2 percent of
total debt, the category grew 13.16 percent
YOY in third quarter 2017. The CMBS, CDO
and other ABS category strengthened, as
its proportion of the debt market rose to
16 percent in third quarter 2017 from 10
percent in third quarter 2016. The origina-
tions by this category increased by 4.53
percent YOY in third quarter 2017. GSE
totaled 13 percent of the debt market, and
gained 6.69 percent YOY in debt levels in
third quarter 2017.
Situs RERC estimates that the total insti- Lender Composition –

tutional equity market was roughly $3.971
Fixed–Income Markets
trillion as of third quarter 2017. At 56 per-
$3.92 Trillion
cent, private equity continued to hold the
majority of equity-based CRE, and was on source Federal Reserve Board, 3Q 2017
par with 2016. REIT investment continued
to account for the next largest piece of the
investor universe, at roughly 24 percent
of total equity. The remaining equity Exhibit 3-D
investment was held by pension funds (10 Institutional Commercial Real Estate Equity Investments
percent), corporations (5 percent), life in-
surers (2 percent), foreign investors (1 per-
cent), commercial banks (1 percent), and
government, GSEs and others (1 percent).
DEBT MARKETS REVIEW

AND OUTLOOK
According to RCA, the loan-to-value (LTV)
ratio for the apartment sector hovered be-
tween 67 percent and 68 percent through-
out 2017, staying at 67 percent at the end
of third quarter 2017. The LTV ratio for
commercial (office, industrial and retail)
was volatile throughout 2017. After falling
to 53 percent in July, the LTV ratio reached
64 percent in September 2017.
The third quarter 2017 Situs RERC Real

Estate Report shows that while institu-
tional investors believe that the availability
of debt capital is very good, perceptions
are that it is significantly below what it
was a few years ago. On a scale from 1 to
10, with 10 being excellent, respondents
rated the availability of debt capital 7.1
in third quarter 2017, compared to 8.3 in
Equity Investor Composition
third quarter 2014. The availability of debt $3.97 Trillion
capital rating has been relatively stable sources NAREIT, NCREIF, RCA, compiled by Situs RERC, 3Q 2017

since fourth quarter 2015. Underwriting includes ratios between 1 and 2.5. The main concern for the CMBS market was
standards appear to be trending upward commercial DSCR was on an increasing on how the new risk retention rules would
since fourth quarter 2015 (indicating in- trend early in 2017, reaching 1.8 percent in impact the market. It appears this market
creased discipline). The discipline of debt May. However, it began a downward trend is beginning to overcome those obstacles,
capital rating declined to 6.8 from 6.9 the in the latter half of the year, sliding to 1.66 with an overall increase in CMBS origina-
previous quarter, but is still one of the percent in September, compared to 1.67 tions in third quarter 2017, reversing a
highest ratings since second quarter 2014, percent in September 2016. The DSCR for multi-quarter trend of falling market share.
when Situs RERC began collecting these the apartment sector has been steadily in-
data. The third quarter 2017 rating is a half creasing over 2017, reaching 1.72 percent in Another obstacle for 2017 was the large
point higher YOY. Underwriting standards September, up from 1.66 percent the same amount of 2007-era maturing debt, and
appear to be moving in tandem with the time last year. These trends indicate steady the manner in which it would be refi-
availability of capital, suggesting stability or improving cash flows for investors, but nanced. According to the CRE Finance
in the debt capital markets. The spread there may be some headwinds for 2018 Council (CREFC), approximately $28.8
between the availability and discipline of DSCR levels due to further interest rate billion of CMBS loans are set to mature in
debt capital index has remained tight since hikes and policy uncertainty. 2018, which will drive refinancing activ-
fourth quarter 2016. ity in the new year. However, this is down
Of particular interest in refinancing is considerably from the $100 billion that
Data on debt yields was provided by delinquencies. Although the pace of new matured in 2017, signifying that the market
RCA. Debt yields have remained steady delinquencies is slowing, the sector most appears to be past the worst of the legacy
throughout 2017, reaching 10.4 percent at risk is retail. Fitch Ratings reports that CMBS hump. The CMBS market ended the
for the retail, industrial and office sectors retail outweighs the other property types first three quarters of 2017 with approxi-
combined, which was an increase of just in current delinquency rate, at 6.12 percent. mately $67 billion in CMBS deals, roughly
less than 1 percentage point YOY in third Trepp reports that approximately $35 $17 billion less than the same time period
quarter 2017. Debt yields for the apart- billion in CMBS debt is made up of retailers in 2016, according to CMA.
ment sector bounced around 9 percent that filed for bankruptcy protection
throughout the year, ending at 9.1 percent in 2017. Looking into 2018, the credit quality
in September 2017. However, debt yields of newly originated and outstanding US
were below the high of 15 percent in 2010 The CMBS lending market declined after CMBS loans is expected to remain near
for the retail, industrial and office sectors, the financial crisis due to the stagnant CRE 2017 levels, according to Moody’s Investors
and 10.5 percent for the apartment sec- fundamentals. Throughout 2016 and the Service. As we near the end of this real
tor seen in 2004. In today’s environment, beginning of 2017, CMBS lending declined estate cycle, the CMBS market will face
property investors are focused more on due to an increase in the yields demanded some challenges through rising interest
debt yield than cap rate compression. Bor- by investors. According to Commercial rates and new supply, particularly in the
rowers are willing to put more equity into Mortgage Alert (CMA), spreads have nar- office and hotel sectors. However, these
a given transaction, keeping LTV ratios rowed in 2017. Spreads on AAA conduits should be somewhat mitigated by increas-
modest, providing less risk and attracting were S+78 as of mid-December 2017, ing debt service coverage in conduit loans,
more institutional investor interest. which is down from the previous week’s declining leverage and declining
spread of S+79 and the 52-week average delinquency rate.
RCA provided trends analysis regarding of 89. Spreads on BBB- conduits were
the debt service coverage ratio (DSCR). S+345 as of mid-December, lower than
According to RCA’s methodology, DSCR both the week prior (S+350) and the 52-
is provided through CMBS tapes and only week average of 400. Going into 2017, the EQUITY MARKETS REVIEW
30
AND OUTLOOK Exhibit 3-E

Roughly $336 billion in CRE acquisitions Real Estate Transactions
occurred through the first three quarters
of 2017, according to RCA. However, this
is less than the roughly $355 billion in
acquisitions during the same period in
2016. Private investors and REITs contrib-
uted the bulk of positive net capital flows
(acquisitions less dispositions) in the first
three quarters of 2017, while foreign inves-
tors and institutional investors contributed
to the decline compared to the first three
quarters of 2016. The YOY decrease is not
surprising given the cyclically high prices;
most market participants did not expect to
reach the record-high transaction volumes
seen in the past two years.
With acquisition activity down, investors

are finding another way to insert capital
into the sector through new construction.
REITs, in particular, saw positive net capital
flows largely due to capital committed
to new construction. Conversely, institu-
tional investors’ pace of new construction
has not been large enough to offset their
disposition activity, contributing to that
sector’s net decrease. Capital volume is
expected to remain active, but tempered,
due to a gap in pricing expectations be-
tween buyers and sellers, tax policy uncer-
tainty, and new supply possibly dampen-
ing income growth.
Foreign investment in the US CRE market

was over $45 billion as of November 2017,
down roughly 31 percent YOY, according to
RCA. This is consistent with the slowdown
seen in transaction volumes across all
property sectors. In 2017, Canada, Singa-
pore and China were the top countries
investing in the US, and the majority of
sources Real Capital Analytics, 2018.

Exhibit 3-F investment, based on transaction volumes,
Commercial Real Estate Acquisitions went to the Manhattan, Washington, D.C.,
and Boston markets. Foreign investment
in US CRE has declined faster than overall
investment; however, it fits the marketwide
trend of waning investment activity after
record years, and is more about reverting
to the norm. Also of note is the decline
in Chinese investment volume. China had
been the leader among cross-border inves-
tors in 2016, but now trails Canada and
Singapore in the face of more stringent
Chinese regulations.
According to RCA, the 2018 outlook for

foreign investment is encouraging. With
ongoing quantitative easing programs oc-
curring in Europe and Japan, many inves-
source Real Capital Analytics, 3Q 2017 tors abroad are finding it harder to fulfill
note Data reflect first three quarters of each year
return requirements through domestic
investment. That, coupled with an increase
in Asian capital into the market, should ac-
count for a continuation of foreign capital
32
into US CRE in spite of the higher cost. This is the lowest rating since third quarter prominent in the pricey gateway markets
The RCA Commercial Property Price Index 2009 and indicates that respondents such as Manhattan, San Francisco and Bos-
(CPPI) National All-Property Index rose 1.2 believe that the market is overpriced rela- ton, while secondary markets like Dallas,
percent in October from a month earlier. tive to value. In general, the value vs. price Houston and Charlotte attracted more in-
The index is up 8.4 percent from a year rating for overall CRE has been trending stitutional investors seeking higher yields.
ago. Since June, the index has registered downward since 2014. Among the prop- CRE equity capital flows also declined
monthly gains of 1.0 percent or higher. erty types, the industrial sector offered
Deal volume in the US has fallen in four the most value relative to price, which
of the past five months even though prices has been the case in every quarter since
have risen steadily. Transaction volume fourth quarter 2011. With its 5.6 rating in
declined 23 percent YOY for all property third quarter 2017, the industrial sector’s
types. Refer to Exhibit 3-E on page 31 to value vs. price rose from 5.3 in second
see a list of top transactions by price quarter 2017 but was down from 6.1 YOY.
in 2017. All the other property types were rated as
overpriced in third quarter 2017, as was the
Situs RERC collects survey data from case in the previous quarter.
institutional investors that uses a scale of 1 CRE equity flows were depressed by a
to 10 (with 10 indicating that value greatly pullback of institutional capital between
outweighs price) to measure the rela- 2016 and 2017 (as seen in Exhibit 3-F).
tive relationship between CRE value and After six years of increasing investment,
price. Situs RERC’s value vs. price rating institutional investors reduced acquisitions
for overall CRE decreased in third quarter by 30 percent through the first half of
2017 to 4.6 from 4.9 the previous quarter. 2017, according to RCA. The decrease was

4THE
PROPERTY
MARKETS
34
INTRODUCTION
RCA reported that total transaction volume increased to approximately
$114.2 billion in third quarter 2017 from approximately $110.6 billion in
second quarter 2017. As shown in Exhibit 4-A, volumes increased for
the industrial and apartment property sectors quarter to quarter, but
dropped for the office, retail and hotel sectors. YOY, total transaction
volume declined 9 percent during third quarter 2017. Transaction volume
for the hotel, retail and office sectors fell precipitously from a year ago —
45 percent, 32 percent and 18 percent, respectively. In contrast, industrial
transaction volume soared 36 percent and apartment transaction volume
rose 5 percent YOY.
According to the RCA CPPI, the apartment sector gained momentum

after a slow start in 2017, growing over 1.0 percent each month from
May through August (see Exhibit 4-B). The pace slowed to 0.9 percent
in September and 0.7 percent in October. The industrial index topped
apartments in October with the fastest YOY growth among the sectors.
Industrial index is up 9.9 percent YOY followed by apartment with its
index up 9.8 percent YOY. The industrial sector has continued to push
the market forward with strong growth while other core types start to
cool. In third quarter 2017, RCA data showed that cap rates for the office
sector increased YOY, cap rates were relatively stable for the retail sec-
tor and cap rates declined for the industrial and apartment sectors (see
Exhibit 4-C).
On a quarterly basis, the average price per square foot/unit (PPSF/PPU)

decreased for the office, retail and hotel property sectors, but increased
for the industrial and apartment sectors in third quarter 2017, accord-
ing to RCA. The office sector experienced its second straight quarterly
decline; retail and hotel fell back after rising in the second quarter. Indus-
trial had been flat in second quarter 2017 while the apartment price per
unit increased for the second consecutive quarter. Compared to a year
ago, the retail sector average PPSF declined approximately 21 percent
during third quarter 2017. This was the most significant YOY decline dur-
ing the past four quarters. While the hotel sector average PPU declined
about 8 percent YOY (the second straight YOY decline over the past
four quarters), the office saw no change from a year ago and the apart-
ment sector prices increased 8 percent. Prices for the industrial sector
increased 9 percent compared to a year ago.
Situs RERC’s value vs. price rating for the office sector slightly dipped
to 4.7 from 4.9 the previous quarter, indicating that the sector is over-
priced. Though ratings have been volatile, the office sector value vs. price
has generally trended downward since fourth quarter 2014. Throughout
2017, the retail sector has been considered overpriced. The current rating,
which declined from 4.7 to 4.4, is the lowest for the property type since
the height of the recession and is currently the most overpriced sec-
tor among the major property types. The apartment sector, after falling
in second quarter 2017 to a 4.3 rating (nearly its lowest value since the
surveys began in 2008), moved back toward equilibrium at 4.8 in third
quarter 2017, according to respondents. The hotel sector dipped slightly
to 4.7 in third quarter 2017 from 4.8 in the previous quarter.
CHAPTER 4 THE PROPERTY MARKETS 35

Exhibit 4-A
Commercial Property Volume
source Real Capital Analytics, 3Q 2017
Exhibit 4-B
Real Capital Analytics CPPI
source Real Capital Analytics, October 2017
Exhibit 4-C
Commercial Property Cap Rates
source Real Capital Analytics, October 2017
36
THE OFFICE MARKET

MARKET One of the greatest predictors of office sector demand is typically Private buyers and institutional inves-
OVERVIEW 1 employment. The unemployment rate was 4.1 percent in third quar- tors/equity funds were the most active
ter 2017, the lowest since 2001. However, the office sector experi- buyers in the market during the first three
enced a stark decline in investment sales during the third quarter quarters of 2017. REITs increased their
of 2017. According to RCA, investment sales in the office sector buying during the three quarters of 2017
totaled $28.4 billion during the third quarter of 2017, a 19 percent compared to the same time in 2016, while
YOY decline (see Exhibit 4-D). The nine-month total in 2017 came cross-border investors retreated their
to $93.5 billion, representing about a 7 percent decline compared level of investments during the same
to the same time last year. CBD office properties had a weak third time period.
quarter with $7.8 billion in sales, down 46.4 percent YOY. CBD
properties captured only $34.9 billion during the first nine months MARKET FUNDAMENTALS2
of 2017, compared to $46.1 billion during the same time in 2016. While national office fundamentals
On the other hand, the sales of suburban properties increased 7 continued on a positive trend line during
percent during the first nine months of 2017, compared to the same 2017, hints of slower growth were seen
time in 2016. over the first nine months of the year.
National office asking rents in the third
Despite a substantial bump in entity sales in third quarter 2017, quarter averaged $29.77 per square foot,
entity volume declined by 51 percent over the first three quarters up from $29.69 and $29.60 in 2Q17 and
of 2017 compared to the same period in 2016. YOY individual sales 1Q17, respectively, according to data from
were down by 8 percent for the first three quarters of 2017, but CoStar (see Exhibit 4-F). Compared to
portfolio sales buoyed the sector with a 12 increase YOY over the the 4 percent growth in office rents of
first three months of 2017. The major US markets attracted most of 2016, the national average office rent rose
the office investment with $49.4 billion in the first three quarters just 1.5 percent YOY in 2017. Office using
of 2017. Non-major market volume was $40.7 billion in the first employment is growing at a slower pace,
three quarters of 2017. Transaction volume differences between the seeing a 1.9 percent increase in new jobs
major and non-major markets was the greatest in first quarter 2017, added to the market year-over-year in
but differences between the markets have declined substantially in 2017, compared to 2.6 percent and 2.9
the second and third quarters, likely due to the increased competi- percent year-over-year in 2016 and 2015,
tion in major markets pushing investors into other markets in the respectively. Office vacancy was almost
search for yield. Transaction volume for both major and non-major entirely flat YOY and registered 10.2
metros decreased YOY, by $4.3 billion and $2.1 billion, respectively. percent in the third quarter, still below the
historical average of 10.9 percent. Annu-
Despite declines in sales, office fundamentals improved, leading alized net absorption has declined this
to rising rents and expectations of stronger cash flows. Accord- year compared to the previous year, and
ing to RCA, the average price for office properties grew a modest was just over 10 million square feet in the
2 percent YOY during the third quarter of 2017, reaching $255 per third quarter. CoStar notes that demand
square foot at the end of September. Prices for CBD properties for four- and five-star space had the high-
declined 1.5 percent YOY in third quarter 2017, while the prices for est vacancy and availability rates of the
suburban offices increased 10.5 percent YOY during the same time three asset classes, yet demand for nicer
reaching an average of $210 per square foot. space is growing at more than double the
pace of lesser-quality space. Office space
RCA reported a slight uptick in the CBD cap rate, reaching 5.7 under construction has been near a mar-
percent during the third quarter of 2017 from 5.5 percent in the first ket cycle peak of just under 150 million
quarter. The suburban cap rate stayed at 6.9 percent. The aver- square feet since 2015. New completions
age cap rate for the overall office sector increased slightly to 6.7 added approximately 60 million square
percent in third quarter from 6.6 percent in the first quarter of 2017 feet of space to the market in 2016, a
(see Exhibit 4-E). number that had already been reached as
the fourth quarter of 2017 opened.
Manhattan retained the top spot for office investment, with $14.8
billion in sales during the first three quarters, but with a 36 percent OUTLOOK
decline compared to the same time in 2016. Los Angeles and San National employment growth, espe-
Francisco ranked second and third during third quarter 2017. The cially in office-using occupations such as
transaction volume in the Los Angeles metro was up 68 percent business and professional services, has
YOY, while the San Francisco metro transaction volume was down 9 remained strong through 2017, despite
percent YOY during third quarter 2017. being more subdued compared to the
1
Unless otherwise noted, the source for the data in this section is Real Capital Analytics.
2
Market fundamentals data for all property types is provided by CoStar Market Analytics (www.costar.com), 3Q 2017.
The information is provided “As Is” and without any representations, warranties or guarantees. CHAPTER 4 THE PROPERTY MARKETS 37
previous year. As the economy reaches Exhibit 4-D
full employment, the employment growth Office Property Volume and Pricing
rate is expected to continue declining in
2018 and the office sector will remain a
top investment destination because of the
stability of the sector. This stability will be
most important for international investors
looking for safe-haven investments amid
Volume ($ Billions)
ongoing geopolitical unrest.
Average $/sf
The office sector faces many headwinds,
however. The combination of low interest
rates and investor demand for the safety
of Class A properties in prime markets
has led to a flood of capital, both for-
eign and domestic, which has driven up
prices in gateway markets. Also, many
institutional investors are holding onto
top properties in core markets, resulting source Real Capital Analytics, 3Q 2017
in a lack of available product and further
driving up prices. Eventually, there will
Exhibit 4-E
likely be a tipping point when institu-
Average Office Property Cap Rate
tional investors flock to secondary and
tertiary markets in the quest for yield.
Positive economic conditions in a number
of secondary markets, including Atlanta,
Minneapolis and Phoenix, will likely add
to the safety of investments in the
smaller markets.
Percent
The office sector is expected to continue

to face changing consumer preferences
from technology requirements, innova-
tive floor plans and flexible work spaces.
As automation and the ability to work
remotely continue to evolve, the need
for traditional office space may be
replaced by more versatile spaces that
decrease the required number of square source Real Capital Analytics, 3Q 2017
feet per employee. Also, new construc-
tion is expected to flood the market in Exhibit 4-F
2018, furthering a slowing of growth in Office Property Vacancy, Net Absorption and Net Completions
office fundamentals.
From a risk-adjusted return perspec-

tive, suburban office has outperformed
CBD office over the last year, accord-
ing to Situs RERC estimates. Tenant
demand for technology-driven innovative
office designs will remain high and older
established offices (such as those in the
CBD) are more likely to have increased
structural constraints in meeting these
demands rather than newer suburban
offices, which likely have a more easily
adaptable infrastructure. As rents rise
in the already high-priced CBD market,
a greater share of tenants are expected
to expand into suburban areas, fostering
source CoStar Market Analytics (www.costar.com), 3Q 2017
further demand for the suburban note The information is provided “As Is” and without
office sector. any representations, warranties or guarantees.
38
THE INDUSTRIAL MARKET

MARKET Industrial assets have been booming, thanks in large part to the REITs and cross-border investors were
OVERVIEW3 growth in e-commerce and manufacturing activity, which have considerably more active during the
sparked a surge in warehouses, fulfillment centers and delivery first three quarters of 2017, compared
services. According to RCA, the transaction volume of industrial to the same time in 2016. Acquisitions
assets during the first three quarters of 2017 was $54.7 billion, a by REIT and cross-border investors
29 percent increase from the same period in 2016 (see Exhibit went up 171 percent and 114 percent,
4-G). The portfolio- and entity-level transaction volumes were respectively. The institutional investors
up 92 percent and 41 percent, respectively, during the first three retreated, with deal volume declin-
quarters of 2017 compared to the same time in 2016. The single- ing by 3 percent during the first three
asset transaction volume was weaker, showing only a 9 per- quarters of 2017 compared to the same
cent rise compared to 2016 during the same period. Regarding period in 2016, according to RCA.
industrial subtypes, warehouse and flex recorded an increase
of 31 percent and 18 percent, respectively, during the first three MARKET FUNDAMENTALS
quarters of 2017 compared to the same time in 2016. Industrial fundamentals continued to
trend upward throughout the first nine
Transaction volume in non-major markets outpaced investment months of 2017. Based on data from
in major markets by about $6 billion in the first three quarters CoStar, demand for industrial space
of 2017. Industrial investment in the major markets topped remained strong with industrial sales
$22 billion and industrial investment in non-major markets was totaling $32.4 billion. In addition, the
over $28 billion. Industrial investment in both market segments first three quarters showed positive net
nearly doubled between second and third quarter 2017. YOY, absorption for industrial space, indicat-
transaction volume also increased for major and non-major ing strong tenant demand in the sector.
markets by $4.6 billion and $3.6 billion, respectively. Based According to CoStar data, net absorp-
on these data from RCA, we conclude that e-commerce will tion totaled 49.1 million square feet in
likely continue to eat up a larger share of retail and demand the third quarter, marking 30 consecu-
for industrial properties is likely to continue rising into the tive quarters of positive net absorption
foreseeable future. (see Exhibit 4-I). Net completions for
the industrial sector totaled 146.8 mil-
Industrial prices kept pace with the increase in transaction lion square feet, 10.7 million square feet
volume. The average price for industrial assets rose about 7 higher than completions recorded in
percent during the first three quarters of 2017 compared to the the first three quarters of 2016.
same period during 2016, based on data from RCA. The national
average for industrial assets reached $81 per square foot by Vacancy rates declined to a national
the end of September 2018. Flex properties traded at $120 per average of 4.9 percent in the industrial
square foot, up 11 percent from third quarter 2016, while ware- sector, 20 bps lower than the average
house properties traded at $72 per square foot, up 6 percent vacancy rate recorded in 2016. Nation-
from third quarter 2016. ally, average industrial rents rose 1.7
percent and 1.5 percent, respectively,
The Los Angeles and Washington, D.C., metros were the most in the first and second quarters of the
active markets in third quarter 2017 with transaction volumes of year. At the end of the third quarter,
$3.7 billion and $2.4 billion, respectively. Chicago, San Francisco industrial spaces were renting for an
and Manhattan rounded out the top five, each with transaction average of $7.29 per square foot, 6.1
volumes of more than $1 billion. percent higher YOY, according
to CoStar.
The industrial sector cap rate remained at 6.9 percent dur-
ing the first and second quarters of 2017, but declined to 6.8 OUTLOOK
percent in the third quarter (see Exhibit 4-H). In general, cap Based on our experience in the market,
rates have been steadily decreasing over the past six years. The we expect that demand for industrial
warehouse and flex subsectors’ cap rates averaged 6.9 percent space is likely to keep rising throughout
during the first three quarters of 2017. 2018, with e-commerce and an increase
in domestic manufacturing providing
tailwinds. With supply lagging in most
3
Unless otherwise noted, the source for the data in this section is Real Capital Analytics.

markets, particularly in urban infill loca- Exhibit 4-G
tions, prices surpassed pre-recession Industrial Property Volume and Pricing
highs for the sector in 2017 (based on
RCA’s CPPI). With decreasing vacancy
and increasing rent growth, the indus-
trial market is stronger than ever. This is
reflected in the 2017 annual total return
Volume ($ Billions)
for the NCREIF NPI, which at almost 13
Average $/sf
percent, is more than double the return
of any of the other property types. The
main driver behind the strong returns
is the healthy mix of appreciation and
income return. A long-awaited increase
in supply is expected to arrive in the
near future, but this supply is not
expected to satiate investor demand
for industrial properties.
Old industrial properties also are
appealing to investors who want to
convert them into condos and apart-
ments. This will likely be most appeal-
Exhibit 4-H
ing for markets that have housing
Average Industrial Property Cap Rate
supply constraints, including parts of
the Miami and New York City markets.
Other markets that are expected to
remain strong for the industrial sector
in 2018 include Los Angeles, the Inland
Empire and Chicago.
Trends in 2018 will likely focus on the

role of technology in fulfillment centers.
Industrial properties will have to meet
the growing space needs for robots
and other automation. Technology in
the trucking industry, such as partially
self-driving trucks, may require special
loading docks and other accommoda-
tions. As the burgeoning e-commerce
trend requires more storage space,
expect that users of industrial space
may demand taller buildings to maxi-
Exhibit 4-I
mize their property’s footprint.
Industrial Property Vacancy, Net Absorption and Net Completions
source CoStar, 3Q 2017
40
THE RETAIL MARKET

INTRODUCTION According to the August 2017 US Census Bureau report, sales in that malls will likely continue to close in
the retail and food service industry are up 3.8 percent since 2016. the near future, because not every mall is
Notable percent changes found in this report support the narrative suitable for a dramatic evolution; one can
we are seeing in the retail real estate market today, with increases be confident that the shopping mall is not
of 3.9 percent, 7.1 percent, and 10.5 percent in motor vehicle & parts yet dead because e-commerce sales in
dealers, building material & garden equipment supplies dealers, and the third quarter 2017 accounted for only
non-store retailers categories, respectively. Decreases were seen 9.1 percent of total retail sales, according
for industries that typically have physical stores: sporting goods, to the US Census Bureau.
hobby, book, and music stores and department stores categories
at 4.6 percent and 3.3 percent, respectively. There is a bifurcation Additionally, a large department store
occurring in the retail sector with certain subtypes performing well operator has recently announced that it
and others being hard hit. will open “experience stores”: retail stores
with no items to purchase, according to
The fate of the shopping mall has been a hot topic in the industry a September 2017 article from CNBC.
for the last few years. CNBC research published in September 2017 These stores will boast a significantly
indicates that many specialty soft-goods tenants are struggling and smaller footprint and will offer personal
even filing for bankruptcy, with apparel tenants finding themselves services ranging from hair and makeup
in the most trouble due to the popularity of online shopping. In appointments, wardrobe styling and pro-
addition, many department stores continue to struggle, which has viding beverages for shoppers to enjoy
been observed with the closure of a significant number of locations while they get to touch, feel and try on
in 2016 and 2017. This is clearly an issue, as department stores or merchandise in-store that they can then
anchors occupy approximately 50 to 70 percent of gross leas- order online.
able area in US shopping malls, according to International Council
of Shopping Centers (ICSC) classification and characteristics and The retail industry has been dealing with
CoStar Realty Information, Inc. While the future of mall retailers is the impact of e-commerce increasingly
up for debate, the future of the physical retail space appears bright for the past decade; however, a new
as malls continue to be redeveloped. Some of the largest mall own- retailing approach called M-commerce
ers and managers are implementing several impressive revamps, has emerged in the marketing world
generally falling into two main camps: entertainment-driven centers that is helping to keep brick-and-mortar
and mixed-use developments. Anchors at entertainment-driven retail alive. M-commerce involves retail-
centers include movie theaters, gyms and party-like concepts, such ers attracting customers and selling
as bowling alleys, indoor mini-golf, or a place with karaoke rooms. products to customers through their
Mixed-use developments feature grocery stores, apartments, office smartphones, which, according to the
buildings and even access to the city’s public transportation sys- Pew Research Center, are owned by
tem, according to an August BisNow.com article, which details five 77 percent of Americans. Retailers are
notable mall redevelopments occurring in the US. While it appears using mobile advertising in their favor by
Exhibit 4-J
Retail (Shops and Strip Centers) Property Volume and Pricing

Exhibit 4-K 60 bps (centers) from their five-year high
Average Retail Property Cap Rate marks.
INVESTOR COMPOSITION
The lender pool remains relatively consis-
tent for this property type, with regional/
local banks making up the majority of
the pool again, according to the August
2017 RCA Trends Report. At 33 percent
Percent
and 24 percent, regional/local banks and

commercial mortgage-backed securities
(CMBS) respectively, make up over half
of the lender pool. It is important to note
that regional/local banks have gradually
increased their dominance in the lender
pool over the past five years, growing
steadily from 12 percent in 2013 to 33
percent in 2017. National banks at 15 per-
source Real Capital Analytics, 3Q 2017 cent and insurance agencies at 13 percent
make up the mid-range of market share,
while financial agencies, international
banks and private/other investors com-
offering coupons via text or email to use $41.5 billion from January through August
bined comprise the remaining 16 percent
in-store, sending proximity-based push 2017, a 20.2 percent decrease compared
of the lender pool. In addition, a similar
notifications of sales in apps or the home to sales of $51.9 billion for the same time
pattern can be seen in the RCA report for
screen, allowing customers to check period in 2016. The shops and centers
the lender composition by submarkets,
in-store availability before arriving in submarkets4 decreased $14.4 billion in
with regional/local banks making up the
person, creating shopping lists, ordering sales for shop space, or 9.7 percent, com-
majority of the lender pool for the centers
products online and picking up in-store, pared to 2016, and sales for center space
(29 percent), shops (42 percent), single-
and providing ease of access for product decreased $36.0 billion or 24.8 percent
tenant retail (46 percent) and unan-
information and reviews. According to (see Exhibit 4-J). Average price per
chored retail (52 percent) submarkets,
a survey from RetailNext, 56 percent of square foot has decreased significantly
while CMBS makes up the majority of the
people favor mobile devices over other in 2017 as well, falling to an average price
remaining anchored retail (33 percent)
devices for browsing and shopping at of $184 per square foot for general retail
and mall (56 percent) submarkets.
home and 95 percent of customers from space as of August 2017, compared to
a survey population make purchases in- $217 per square foot as of August 2016,
Private investors continue to own the
store based on mobile ads. In addition, and $220 per square foot as of August
majority of the buyer pool at 53 percent,
an article in The Atlantic indicates mobile 2015. According to RCA, this may indicate
according to the August 2017 RCA Trends
shopping accounted for a 20 percent a normalizing market, as the average
Report, which has remained consistent
share of total digital dollars spent in the price per square foot values from 2015
over the past five years. However, listed
third quarter of 2016. By offering the and 2016 appear to have been at their
REITS have taken over the second largest
personalization that consumers crave, high marks in those years, compared to
share from institutional funds, with each
retailers are using people’s dependence lower or more similar values in 2013
category making up 23 percent and 16
on their mobile phones to draw them into and 2014.
percent of the pool, respectively, versus
their physical stores.
representing 10 percent and 27 percent
AVERAGE RETAIL in 2016. Cross-border investors’ market
The changing ways of how Americans PROPERTY CAP RATES share continues to shrink as it has since
consume has kept real estate owners on Average cap rates remain stable, show-
its high mark of 10 percent 2015, down to
their toes. However, by getting to know ing no change since Q1 2016, according to
5 percent of the buyer pool, while inves-
their customers, certain retailers have RCA, which shows cap rates remaining at
tors in the user/other category make up
learned how to accommodate to chang- 6.5 percent for the general retail market
another steady 3 percent of the pool.
ing consumer preferences. Retailers are since that time. Cap rates for the shops
taking steps to ensure physical stores will and centers submarkets follow this trend,
RETAIL PROPERTY FUNDAMENTALS
not be going away completely as some with shops cap rates remaining stable at
According to a Market Analysis and
may have previously believed. CRE own- 5.9 percent since Q4 2015, and cap rates
Forecast Report from CoStar, vacancy
ers can adapt by finding quality tenants for centers remaining at 7.0 percent since
rates have remained stable year over year,
to occupy pre-existing large spaces and 2016 for the majority of 2017, dropping
currently at 4.9 percent for the market
developing new store concepts. 10 bps to 6.9 percent in August 2017 (see
overall which is a 12-month change of
Exhibit 4-K). All three retail categories
-0.1 percentage points. Malls have the
RETAIL PROPERTY are representative of their lowest average
lowest vacancy rates at 3.7 percent, fol-
VOLUME AND PRICING cap rates in the past five years, down 80
lowed by power centers at 4.7 percent
According to RCA, volume of US retail bps (general retail), 110 bps (shops) and
and neighborhood centers at 7.7 percent.
property sales totaled approximately
According to the CoStar report, vacancy
4
RCA’s definitions for retail submarkets are:
Shops: Retail space usually occupied by a single tenant and/or under 30k sf
©2018 Deloitte Development LLC, National Association of REALTORS®, 2018 Situs RERC. Centers: Retail space consisting of multiple tenants and 30k sf or more
42
will continue to decline into 2018, dipping Exhibit 4-L

to 4.8 percent before increasing over Retail Net Completions, Vacancy and Net Absorption Rate
the following four years reaching above
5 percent. It appears the increase in
vacancy is due to a greater supply com-
ing online than annual absorption.
In 2017, more than 65 million square feet

of retail space was absorbed compared to
over 57 million square feet of space deliv-
ered, according to CoStar (see Exhibit
4-L). Both of these estimates are down
from the historical averages of 110 million
square feet and 109 million square feet
respectively for absorption and deliveries.
Further, the current metrics are a fraction
of absorption and delivery figures from
the market’s peak in 2006 when both
were greater than 200 million square feet.
With 2018 inventory to be even less than source CoStar, 3Q 2017
2017 and absorption expected to increase OUTLOOK us back to normalized levels. As retail-
slightly, CoStar is forecasting a further The panic seems to have dissipated ers combine physical store experiences
reduction in vacancy. However, the gain among the retail real estate industry this withe-commerce and m-commerce strat-
from positive absorption is still small year, despite news about store closures egies, the outlook for the future appears
compared to the 400 million square feet and brand bankruptcies. However, as IHL moderately promising.
currently vacant. Group points out, the US retail market
is extremely overbuilt compared to the
Net asking rents for malls, power centers rest of the world. IHL Group states that
and neighborhood shopping centers malls have been developed at a rate of
averaged $27.83, $22.35 and $20.07 per four times the population growth in the
square foot respectively, according to US since 1975, with cheap money and the
CoStar. This represents approximately a availability of land serving as contribut-
2.8, 2.6 and 2.3 percent increase over net ing factors. An article in The Atlantic
asking rents for the same quarter in 2016 points out that the US has 40 percent
for malls, power centers and neighbor- more shopping space per capita than
hood shopping centers, respectively. Canada, 10 percent more than Germany,
According to the Market Analysis and and 5 percent more than the UK. With
Forecast Report from CoStar, rent growth this in mind, the closures we are seeing
is forecast to be 2.1 percent for malls, 1.9 may not be leading to a bottoming-out
percent for power centers and 1.7 percent of the brick-and-mortar retail industry,
for neighborhood centers in 2018. but rather could be helping in bringing

THE APARTMENT MARKET
INTRODUCTION After a long run as the dominant performer among the major prop- Cap rates for mid/high-rise properties
erty types, the apartment market is finally beginning to show signs dipped into sub-5 percent territory in the
of cooling down. US apartment volume has increased every year fourth quarter of 2016 (at 4.9 percent),
since 2009, but 2016 growth was just marginally positive YOY at 4 but have increased back to 5 percent as
percent, based on RCA data. A total of $103.9 billion of significant of third quarter 2017. For garden-style
apartment properties were sold in the first three quarters of 2017, properties, cap rates have dropped from
representing a YOY decrease of 8.6 percent (see Exhibit 4-M). an average of 5.9 percent in the first
At its current pace, the YOY volume change for the 2017 calendar three quarters of 2016 to an average of
year will fall well short of the prior year. This is notable considering 5.7 percent over the same time period in
the seven consecutive years of growth and may signal changes in the current year. In both cases, the rates
this property sector, which has been favored by investors for many are well below historical levels, reflect-
years. Then again, volume in CRE is down overall with just one of ing the availability of capital, low interest
the other major property sectors (industrial) experiencing a posi- rates and the high demand for this prop-
tive YOY volume change in the first three quarters of 2017, indicat- erty type. However, it does appear that
ing an overall slowdown in the CRE investment class. demand and pricing for mid/high-rise
apartments may have met some upward
Among apartment types, both garden-style and mid/high-rise resistance as reflected in both the
apartment properties observed very similar overall declines in volume and cap rate trends for this
volume in the first three quarters of 2017. Consistent with 2016, apartment type.
garden-style apartments accounted for approximately 70 percent
of the total sales volume over this time period. With the potential for rising interest rates
and a greater proportion of transactions
occurring in secondary and tertiary mar-
kets from investors seeking opportunities
for higher yields, it appears that overall
... THE APARTMENT MARKET IS average cap rates may continue to stabi-
lize or possibly increase in 2018.
BEGINNING TO SHOW SIGNS INVESTOR COMPOSITION
OF COOLING DOWN. Private investors have overwhelmingly
dominated the market in the first half of
2017, representing 64 percent of all trans-
action activity, based on RCA data. This
is an increase from 62 percent in 2016.
Investors are continuing to focus outside of the major urban areas, The second largest group of buyers has
with YOY sales volume declines of just 4 percent and 5 percent for been institutions/funds at 24 percent, a
secondary and tertiary markets, respectively, compared to 18 per- decrease from 26 percent in 2016.
cent for major metro markets. While all of these geographic market
trends are negative, the data appear to indicate that opportunities Greystar Real Estate Partners, which
for reasonable yields in urban mid/high-rise apartments have fur- acquired luxury apartment developer
ther diminished in recent years in favor of higher-yielding opportu- Monogram Residential Trust Inc. (MORE)
nities in garden-style apartments in non-core markets. in the third quarter of 2017 for approxi-
mately $4.4 billion (including the PGGM
Based on the RCA CPPI, pricing for apartment properties nationally JV and debt assumed or refinanced), was
has increased approximately 10 percent YOY through August 2017. the second most active buyer (in terms
The average PPU has increased marginally, averaging $143,045 in of investment volume), according to
2016 compared to $142,317 in the first three quarters of the prior RCA. Other notable buyers were GIC and
year, per RCA. APG Group (both investors in the MORE
acquisition), Starwood Capital and Caisse
As presented in Exhibit 4-N, average cap rates for the apartment de Depot. After MORE, Milestone Apart-
sector have remained relatively stable over the last year, decreas- ments REIT, Starwood Capital and JP
ing slightly to an average of 5.6 percent in the first three quarters Morgan were the top sellers during
of 2017 from an average of 5.7 percent over the same period in the the period.
prior year.
44
Through the first three quarters of 2017, Exhibit 4-M

the geographic areas leading in terms of Apartment Property Volume and Pricing
transaction sales volume for apartment
properties include Dallas, Los Angeles,
Atlanta and Denver, according to RCA.
Average in Thousands $/Unit

However, markets exhibiting the biggest
YOY increases include Washington, D.C.,
Volume in $ Billions
and San Antonio. Notably, Manhattan has
experienced the biggest YOY decline and
is outside the top 10 most active markets
through the first three quarters of 2017.
For comparison, Manhattan was the sec-
ond most active market in 2016, and the
most active market in 2015.
Strong sector fundamentals and intense

competition has led to a significant pipe-
line of new apartment projects. Accord-
ing to Axiometrics, a RealPage company, source Real Capital Analytics, 3Q 2017
365,158 apartment units are expected to
be delivered in 2017, followed by 376,221
and 307,950 more units in 2018 and 2019,
respectively. These figures are signifi- Exhibit 4-N
cant compared to the average annual Average Apartment Property Cap Rate
new supply built in 2010 through 2012 of
just 132,632 units. As noted by the data
above, new supply is projected to peak
in 2018. The total apartment stock as of
third quarter 2017 was approximately 25
million units.
Percent
APARTMENT
PROPERTY FUNDAMENTALS
Continuing upon a trend that started in
2016, property fundamentals in the apart-
ment sector have weakened through 2017.
According to Axiometrics, annual effec-
tive rent growth was 2.4 percent in third
quarter 2017, a decline from 3.8 percent
in the prior year and less than half of the
rate of growth of 4.9 percent in the same source Real Capital Analytics, 3Q 2017
quarter of 2015 (see Exhibit 4-O). Annual
effective rent growth is forecast to remain
under 3 percent over the next two years,
according to Axiometrics.
Exhibit 4-O
Apartment Market Vacancy and Effective Rental Rate Growth
Since the apartment recovery began in
late 2009, the vacancy rate fell in 27 con-
secutive quarters from 8.1 percent to 4.9
percent in third quarter 2016 (see Exhibit
4-O). However, since then the vacancy
rate has inched up slightly in 2017 to 5.2
percent in the third quarter. The vacancy
rate is expected to remain in the 5 per-
cent territory over the next several years,
per Axiometrics.
OUTLOOK
Trends in transaction volume and fun-
damentals appear to suggest potential
challenges for the darling of the major
property types in the current real
estate cycle. source Axiometrics, a RealPage Company, 3Q 2017

The homeownership rate, which has
been in sharp decline throughout the
current real estate cycle and a major
driver behind the strength of the apart-
ment market, appears to have bottomed
out in 2016 and has increased slightly in
2017. This is notable considering that the
homeownership rate has been a major
driver behind the strength of the apart-
ment market after dropping from over 69
percent in 2004 to under 63 percent in
2016. Households under age 35 (i.e., the
millennials) were the only age group to
experience an increase in homeownership
rate over the last quarter. Although
a small proportion of the total population,
this may provide some indication of a
change of own vs. rent preferences of
a key segment of the population and
could pose future headwinds to the
apartment sector.
It remains to be seen if the homeowner-

ship rate will stabilize or begin to reverse
course. However, with the supply of
apartment units projected to remain at
a high level over the next several years,
a shift on the demand side with renters
turning into homebuyers could have a
major impact on this sector. It remains
to be seen whether the new tax act will
impact homeownership rates. The cap on
deductible mortgage interest and limita-
tion on deduction of property taxes may
lead to consumer preference for renting
instead of buying.
Given the considerations above, the

apartment sector overall appears to be
experiencing early signs of a slowdown
and it appears likely that this trend may
continue into 2018. However, relative to
the other major property types, apart-
ments still appear to be a popular choice
among investors given the level of trans-
action volume and pricing.
46
THE HOTEL MARKET

INTRODUCTION The current hotel market expansion is on a historic run, but despite While transaction volume continues
the impressive performance, deal volume has sharply declined and to slow, there has been focused atten-
cap rates are rising. Of greatest concern is the flat to declining deal tion from investors on non-major metro
volume and the first YOY decrease in US hotel construction since markets and the limited service segment.
2011. The data signal concern that future market fundamentals and For the first three quarters of 2017, full-
current pricing may be moderating. In the near term, a temporary service recorded a 0.5 percent increase in
slowdown in volume and pricing can be expected as investors average PPU, but a 38 percent decrease
realign risk and return assumptions. in volume compared to the same three-
quarter span in 2016 and limited-service
TRANSACTION TRENDS a 5.4 percent increase in PPU and a 15
The current market cycle for hotel investment has been slowing percent increase in volume7.
in breadth and depth. As of third quarter 2017, the YTD transac-
tion volume for all hotels was $21.5 billion, according to RCA (see Although full-service hotel deals domi-
Exhibit 4-P). In comparison, the same YTD transaction volume nated transaction volume in both mar-
recorded for 2015 and 2016 was 78 percent and 44 percent higher, kets, the non-major metro markets
respectively, supporting a deceleration trend. It is important to continue to be more dominant in limited-
note that in previous years, megadeal and full-service transactions service hotel deal volume. Contrary to the
buoyed deal volume; however, such transactions faded in 2017. relatively flat deal volume for full-service
Access to capital does not appear to be the issue; rather, investors hotels, transaction volume for limited-
are likely uncertain about future performance. With over 340,000 service hotels reversed the 2016 trend
rooms added since 20075, transaction volume continues to lag and is up in both major and non-major
behind previous highs recorded in 2006. metro locations —by approximately 15
percent and 19 percent, respectively YOY.
The sales volume shift in the current cycle marks a change in geo- PPU for non-major metro, limited-service
graphic preference. Hotel transaction volume has slowed dramati- hotels was $78,437, up by approximately
cally in five out of the six top major markets6. Manhattan, a peren- 6 percent from our previous report8 . The
nial top sale volume market, slipped to number three, whereas Los outlook for the subsector appears to be
Angeles (44 percent volume increase) assumed the top position favorable, as demand growth has out-
followed by Atlanta (6 percent volume increase), both primarily paced supply YTD through September 9.
supported by single-asset sales. Charlotte reported 1,124 percent
sale volume growth; however, two sales, Marriott City Center and These data are well-reflected in RCA’s
a portfolio of four hotels, represented half of the deal volume transaction-based cap rate trends, as
reported. Other markets, such as Dallas, Philadelphia, Houston and shown in Exhibit 4-Q. Although hotel
Baltimore, recorded strong growth, as well, primarily due to inves- fundamentals are generally stable and at
tor interest in the limited-service segment. historical records, the industry is dealing
Exhibit 4-P
Hotel Property Volume and Pricing

5
CBRE, Historical Database, 1Q2007 to 2Q2017 8
Ibid
6
Manhattan, San Francisco, Chicago, Los Angeles, Boston and Washington, D.C. 9
STR, Inc., US Industry Performance-Steve Hood, September 2017
7
Trend Tracker, Real Capital Analytics, trailing 12-month average, data as of
October 24, 2017 CHAPTER 4 THE PROPERTY MARKETS 47
with competitive disruptions, new supply by the end of 2016, but never decreased. 2.0 percent during the same period (see
primarily impacting luxury and upper- Furthermore, occupancy growth Exhibit 4-S). Occupancy levels are still
upscale segments, and generally increas- increased slightly through third quarter expected to remain above the long-run
ing cap rates. After a meaningful increase 2017, primarily supported by leisure and average of 62 percent12. Overall, hotel
in full-service and limited-service hotel corporate travelers. ADR increases have fundamentals are expected to remain
cap rates, the trend slowed over the last been averaging over than 4 percent over relatively stable, with limited changes in
two quarters of 2016. Based on a trailing the past five years, but the increase has occupancy, slight ADR increases and fad-
12-month cap rate average, only major slowed most recently to approximately 2.1 ing demand.
metro full-service segment cap rates percent11. There continues to be a lack of
compressed (-12 bps), whereas major demand in the group segment, but group As of October 2017, approximately
and non-major metro limited service ADR increases have outpaced transient 584,052 rooms in 4,869 hotels projects
increased (27 to 74 bps) and non-major ADR increases. Despite historically high were under contract in the US, represent-
metro full service segment increased (4 occupancy for the hotel sector, ADR ing a 5.4 percent increase compared to
bps) as well10. growth remains measured. October 201613. Of the under-contract
announcements, 1,407 hotel projects
Comparatively, nationwide full-service CBRE Hotels’ Americas Research are currently under construction, repre-
hotel cap rates were 15 bps lower and reported that occupancy remained rela- senting 183,187 rooms and a 0.1 percent
limited-service hotel cap rates were 39 tively flat in the mid-60 percent range decrease in YOY comparisons. During the
bps higher in third quarter 2017 from through the first three quarters of 2017, last four quarters, CBRE Hotels’ Ameri-
same period last year. For both subtypes, with the ADR increase trending at about cas Research reported that hotel supply
the cause may be directly related to slow-
ing demand, quality of the asset, supply
additions and interest rate pressure. Exhibit 4-Q
Average Cap Rates for Hotel Sector
Foreign capital investment in the hotel
sector slowed after record investment in
2016. With approximately $6.1 billion in
acquisitions on a 12-month trailing basis,
third-quarter data from RCA show that
cross-border investors completed 20
percent of total hotel acquisitions, down
from approximately 28 percent for the
same period last year. Cross-border inves-
tors appear to be out of the market, likely
digesting the $13.1 billion in acquisitions
completed in 2016, more than double
2017 totals. YTD, the cross-border group
represented only 4 percent of total hotel
depositions, which is characteristic of
their long-term hold strategy. source Real Capital Analytics, 3Q 2017
In 2017, the change in acquisition com-

position has been dominated by private
investors. During the trailing 12 months, Exhibit 4-R
private investors acquired $15 billion, or Composition of Hotel Acquisitions and Dispositions
48 percent of total hotel sales, per RCA.
Although the recent transactions con-
tinue to be unique, prices are at accept-
able levels to allow a clean exit for many
of those who had purchased properties
during previous cycles. As of third quarter
2017, private investors have sold $13 bil-
lion, or 42 percent, of hotel dispositions
during the past 12 months. For a historical
comparison of investor composition, refer
to Exhibit 4-R.
FUNDAMENTALS
With occupancy at all-time highs, hotel
average daily rate (ADR) is playing a sig-
nificant part in maintaining fundamentals.
As expected, occupancy rates leveled off source Real Capital Analytics, 3Q 2017
10
Trend Tracker, Real Capital Analytics, data as of October 24, 2017 12
Hotel Horizons, Volume XI – Issue IV, CBRE Hotels’ Americas Research, December 2017
11
STR, Inc., Total US, ADR & OCC % Change, 12 MMA as of September 2017 13
STR, Inc., US Hotel Pipeline for October 2017
48
increased by a soft 1.8 percent of the down from 3.1 percent in the previous 30 consecutive quarters of growth in
existing hotel room base, while demand year. Revenue growth for hotel owners lodging demand since the fourth quarter
increased by 2.4 percent of the exist- should continue in 2018, however, but at of 2009. CBRE Hotels’ Americas Research
ing hotel room base. In previous years, a slower pace. With occupancy expected predicts continued demand growth
demand growth dominated, reflecting to remain at current levels, it is expected outpacing new supply until 2020, when a
net supply/demand differentials in excess that ADR will continue its expansion, but supply overrun results in occupancy levels
of 3.5 percent in some years. In 2017 and below long-term averages. decreasing less than 1 percent. Upscale
into 2018, the supply and demand are In general, the outlook appears to be hotel segments will continue to lead all
expected to be in near-equilibrium and mixed for hotels, with stable fundamen- hotel segments in demand, but demand
very much in line with long-term aver- tals but slowing transaction activity and benefits may be muted by high supply
ages. New supply is projected to be 1.8 rising cap rates. Strength and stability additions in this segment.
percent to 2.0 percent in 2018, 2019 and in profitability forecasts should balance
2021 annually, as shown in Exhibit 4-T. a slight momentary lapse in growth and Despite high occupancy levels, the pace
disruption from new supply. of ADR growth is expected to continue.
Hotel fundamentals were positive through CBRE Hotels’ Americas Research projects
the first three quarters of 2017; how- OUTLOOK that room rates will grow by 2.2 percent
ever, the future is somewhat uncertain. The demand for US lodging continued to in 2017, followed by another 2.5 percent
CBRE Hotels’ Americas Research reports increase through the first half of 2017. Per in 2018, but record less than 2 percent
that ADR is likely to finish 2017 with an STR, lodging demand grew by 2.5 percent growth for 2019 and 2021. Because they
increase by 2.5 percent year over year, during the first half of the year. This marks lagged during the initial stages of the
CRE market recovery, economy proper-
ties, along with those in secondary or
Exhibit 4-S tertiary markets, are now projected to
Hotel ADR and Occupancy achieve the greatest gains in ADR and
revenue per available room (RevPAR).
On the other end of the spectrum,

luxury and upper-upscale properties are
Average Daily Rate ($)

forecast to attain the highest occupancy
levels. Given the modest forecast for
Occupancy (%)
RevPAR growth over the next few years,

management’s ability to control costs will
determine continued profit growth.
Hotel cap rates have been trending up

over the past two years, more in part due
to changes in target markets/segments
and buyer types rather than a perva-
sive trend across the industry. Cap rates
source CBRE Hotels’ Americas Research, STR, 3Q 2017 for the overall hotel sector are likely to
note Shaded area reflects forecast rates increase in the long term; however, top
metro properties, trophy and upper-tier
properties may lag due to strong demand
Exhibit 4-T for quality and long-term security. Rising
Hotel Supply vs. Demand Growth interest rates will certainly impact the
tightening of the equity spread and may
accelerate pressure on additional cap rate
increases. In this circumstance, contin-
ued sluggish transaction volume can be
expected as investors pause to evaluate
their risk and return assumptions.
source CBRE Hotels’ Americas Research, STR, 3Q 2017

5SUMMARY
& OUTLOOK
50
INTRODUCTION
2017 might reasonably be considered one of the most chaotic
years in a long time. Some of the events included the nationwide
women’s march on the day after President Trump’s inauguration,
the WannaCry ransomware attack, terror attacks around the world,
a sarin gas attack in Syria (followed by the US’s retaliatory mis-
sile strikes), tensions with Russia, bellicose threats between North
Korea and the US, catastrophic hurricanes, California wildfires, and
the US pullout from the Paris Agreement on climate change.
But none of this appeared to have too much effect on the economy.
The stock market reached a record high, with the Dow spiking
almost 8,000 points — about 42 percent — from President Trump’s
election in November 2016 to the third week of 2018. According
to a CNBC report, hedge fund managers’ equity exposure is at the
highest level since 2006 as the possibility of market downturn has
fallen to its lowest level since 2013. The same report stated that the
exchange-traded funds attracted more than $16.5 billion in cash
the first two weeks of 2018. While the optimism in the equity mar-
ket is fueled by strong earnings, the hopes of synchronized global
growth and the US tax reform, the exuberance in the stock market
may mean that a crash is looming.
The bigger risk may be in the bond market. The 10-year Treasury
yields have been rising since the tax reform bill was passed in
December 2017. Further rate hikes and shrinkage of the Fed’s bal-
ance sheet will likely put more upward pressure on bond yields.
Rising yields means lower prices, which translates to lower capital
appreciation for fixed-income investors. Reduced bond purchases
from global central banks, and stronger inflation and higher budget
deficits powered by the new US tax code, inspire a bearish forecast
for the bond market.
As both the stock and bond markets face headwinds, it is no

wonder that investors are nervous. When you add in the geopoliti-
cal situation, investors are questioning how best to position their
portfolios. CRE could be a source of stability in this frenzied envi-
ronment. CRE fundamentals are still strong, with low vacancy rates
and stable rents, and the lending standards are conservative, based
on data from CoStar and Situs RERC.
The new US tax code is expected to be a boon for the CRE sector,
and that should make investors more confident. Most of the tax
breaks for real estate investors remain intact or improved in the
new tax code. Perhaps the biggest win will be for the individuals
and family offices investing in real estate through partnership enti-
ties and the way pass-through income is taxed under the new code.
Owners of pass-through businesses will be taxed at individual rates
less a deduction of up to 20 percent, cutting the effective tax rate
for many filers. Moreover, the corporate tax cuts are expected to
spur business investments and hiring. Job growth has always been
a critical driver of real estate demand. If job growth is supported by
CHAPTER 5 SUMMARY & OUTLOOK 51

higher wages, the demand for CRE will be between solid demand and insufficient special treatment traditionally reserved
even stronger. supply, leading to price growth outpacing for long-term capital gains and certain
wage growth. Low unemployment and qualified dividends.
In addition to providing some stability in rising wages are expected to make home-
a risk environment, investors should be ownership increasingly attractive, but as SITUS RERC 10-YEAR
attracted to CRE as they provide regu- the tight inventory of new and existing TREASURY FORECAST
lar cash flow in the form of rent, which homes continues — at the same time as Interest rates, and what is going to hap-
can sometimes serve as a hedge against more young buyers enter the market — pen to them, have been a major focus
inflation. Likewise, CRE performance housing prices are expected to outpace for investors since the end of the Great
has low correlation with financial market wage growth. Recession. Over the past nine years of
performance. Investments in assets such forecasting rates, we have learned that
as multifamily and health care properties LEGISLATION our belief that rates would return to his-
provide downside protection to portfolios In 2017, President Trump aggressively torical levels has not panned out. Con-
as people will always need health care worked to eliminate or reverse numer- sidering today’s compressed cap rates
and a place to live. Most importantly, CRE ous federal regulations, saying the rules and, more importantly, expected total
provides the diversification that is essen- were stifling economic growth. Perhaps long-term returns (IRRs and discount
tial to any investor’s portfolio. his most significant action in this area rates), the direction of interest rates is a
was convincing Congress to overturn a crucial factor that could quickly change
OUTLOOK FOR 2018: Consumer Financial Protection Bureau the dynamics of all mainstream asset
ECONOMY (CFPB) rule designed to make it easier classes, including CRE. Higher interest
Steady economic growth is predicted for for consumers to file class-action lawsuits rates are a mixed bag for CRE investors,
the US in 2018, continuing the historically against financial institutions. More finan- signaling confidence in the economy but
long expansion and raising the cost of capital.
boosted by the pack- The Fed raised short-term
age of tax cuts passed interest rates three times in
by Congress at the
end of 2017. The US IF JOB GROWTH IS SUPPORTED 2017 and began shrinking its
balance sheet, which peaked
unemployment rate,
which fell during 2017
BY HIGHER WAGES, DEMAND FOR at about $4.5 trillion. The
10-year Treasury rate was
from 4.8 percent to 4.1
percent, will likely stay
CRE WILL BE EVEN STRONGER. 2.24 percent for third quarter
2017. Situs RERC forecasts
low in 2018 and may the 10-year Treasury because
drop below 4.0 per- of its critical importance for
cent if faster economic the CRE market. The three
growth and moderate wage growth cial regulations are expected to go by scenarios below describe Situs RERC’s
occur. Interest rates are predicted to keep the wayside in 2018; the CFPB is now run 10-year Treasury rate forecast as of third
rising, as the Fed has signaled that there by acting director Mike Mulvaney, who is quarter 2017 (see Exhibit 5-A).
will be three more hikes in increments of also director of the Office of Management
25 bps in 2018; however, an increase in and Budget. Mulvaney is a long-time • The base case scenario reflects the
the federal deficit brought on by the tax critic of the agency he now heads, and is most probable economic situation
cuts might spur the Fed to raise inter- expected to slow down or stop impend- over the next two years, with rates
est rates further to prevent an outbreak ing restrictions on payday lending, debt increasing steadily throughout 2018
of inflation, which has remained in the 2 collection and overdraft fees. and 2019. This assumes that the
percent range or lower for several years. FOMC will continue to increase short-
The federal deficit will continue to grow CRE can expect changes in 2018, many term rates in 2018 and the historic
unless Congress cuts spending or the tax due to the new tax reform law — but not wind-down of the $4.5 trillion bal-
cuts pay for themselves through higher as dramatic as some feared because ance sheet will be gradual enough to
growth that brings in more revenue to many proposals that were opposed by avoid disrupting markets. The tight
offset the tax reductions. people in the industry did not make the labor market will provide additional
final draft. For real estate investors, the boost to the economy. The base case
Under the most likely economic scenario, new law offers only modest changes for scenario sees the 10-year Treasury
consumer and business spending are how they do business regarding 1031 tax- rate increasing to 2.80 percent by
expected to continue to grow in 2018, deferred exchanges, mortgage interest fourth quarter 2018 and reaching
thanks to higher wages, lower corporate deductibility and asset depreciation. The 3.20 percent by the end of 2019.
tax rates and more consumer confidence. real estate industry is exempt from some
We predict that there will be an improved new limits on deductions for interest pay- • The lower case scenario reflects a
balance of trade with growth in the manu- ments, and on the ability to defer taxes on more pessimistic, and less likely,
facturing sector spurring an increase in the exchange of similar kinds of property. economic situation. In this scenario,
imports. Real estate investors will be able to use Situs RERC predicts that the 10-year
a more generous depreciation timetable, Treasury declines to 2.10 percent
However, the affordability squeeze in allowing owners to shelter more income. by fourth quarter 2018 and to 1.62
residential real estate is expected to Rental and mortgage-interest income will percent by the end of 2019. This
continue in 2018 due to an imbalance qualify for a lower tax rate, the kind of scenario assumes a failure of the
52
current administration to reach an Exhibit 5-A

agreement on policies. In this sce- Situs RERC 10-Year Treasury Forecast
nario, the economy cools off sooner
than expected. As a result, the FOMC
delays additional rate increases and
slows its reversal of quantitative eas-
ing. Global political and economic
uncertainties push investors out of
other asset classes to Treasurys in a
flight to safety.
• The higher case scenario assumes

strong economic growth but has
a lower probability of happening
than the base case scenario. In this
scenario, Situs RERC predicts the
10-year Treasury increasing from 2.24
percent in third quarter 2017 to 3.75 source Federal Reserve, compiled and forecasted by Situs RERC, 3Q 2017
percent in fourth quarter 2018 and note Shaded area reflects forecast rates
swelling to 4.18 percent by the end of
2019. The upside scenario assumes
the tax reform bill achieves its goals,
which will fuel growth throughout
the year and drive the Treasury rate
higher. The 10-year Treasury will keep
trending up in 2019 as the Fed’s bal-
ance sheet reduction plan goes into
high gear. This scenario also assumes
that new Fed Chairman Jerome
Powell will pursue a reasonably
more aggressive path of monetary
tightening.
The most likely prediction is that the Trea-

sury rate will increase over the next two
years. The concern for the CRE market
is not just that short-term and long-term
rate increases are anticipated, but that
they are expected to rise at the same time
that CRE capital returns are likely to flat-
ten and decline in some cases. Property
types such as office and retail have the
potential to be hit hardest by rising rates
because of locked-in leases. As uncer-
tainty in the CRE market over the tim-
ing of the next correction increases, the
potential increases for rising interest rates
to tip the scale in favor of safer long-term
bonds. However, interest rates still remain
far below historical averages and spreads
between CRE yields and the 10-year Trea-
sury are commensurate with spreads seen
in previous recovery periods, with yields
supporting the risk premium. The inter-
pretation is that the CRE market is likely
to be stable for at least the next year.
CAPITAL MARKETS
Regarding debt capital markets, under-
writing standards appear to be mov-
ing in tandem with the availability of
capital, suggesting stability for the near
future. LTV ratios are expected to remain

modest, providing less risk and attract- rise in e-commerce and will remain the
ing more institutional investor inter- most volatile property type in 2018. Store
est. For the DSCR, steady or improving closings and bankruptcies have shaken
cash flows are expected for investors, investor confidence in this property type.
but there might be some headwinds in However, some brick-and-mortar stores
2018 because of rising interest rates and will be able to withstand the pressures
general policy uncertainty. The credit from e-commerce by repositioning them-
quality of newly originated and outstand- selves to provide experiential shopping
ing US CMBS loans is expected to remain to consumers. Also, what has been the
near 2017 levels, according to Moody’s bane for the retail sector has been a boon
Investors Service. The CMBS market for the industrial sector. Energized by
is expected to face some challenges e-commerce, a reinvented supply chain
through rising interest rates and new and solid retail sales, the industrial sector
supply, particularly in the office and hotel remains the darling of CRE. Vacancy con-
sectors, but it could be offset by increas- tinues to reach record lows, even as rents
ing debt service coverage in conduit keep rising. Construction has boomed as
loans, declining leverage and declining operators work to keep up with the ever-
delinquency rate. changing supply chain and online delivery
of goods. Although the rate of increase
REITs have proven to be an attractive in industrial asking rents will slow as new
investment with positive net capital flows supply hits the market, industrial will
thanks in large party to capital commit- continue to be the sector investors flock
ted to new construction. Capital volume to. Because the hotel sector is closely
is expected to remain active in the near tied to economic performance, the sector
future but might be tempered by a gap in suffered from the effects of hurricanes
pricing expectations between sellers and and political turmoil in late 2017, and is
buyers, some tax policy uncertainty and also working through a large amount of
enough new supply to dampen income supply. However, in its key metrics, the
growth. hotel sector is performing well compared
to one year ago. US occupancy recorded
CRE FUNDAMENTALS monthly highs in 2017, the ADR is steady,
In today’s environment, investing can be and RevPAR has been increasing YOY
a risky business. Many asset classes, such since the Great Recession. Multifamily is
as stocks, may be reaching new highs but the only sector to see a rise in vacancy,
come with an element of volatility as they as new apartments continue to become
are also highly susceptible to changes in ready for occupancy. The abundance of
the political and economic climate. As new apartment construction has kept
an asset class, CRE is less vulnerable to rents mostly flat, despite solid absorption.
these changes, providing more stable Demand in the multifamily market could
returns for investors even as cap rate see an increase due to the new tax laws
compression begins to stall. As we near cutting some of the benefits of homeown-
the end of one of the longest economic ership, making renting more attractive.
expansions in US history, CRE investing
can continue to be a secure way to build SITUS RERC TOTAL
wealth by carefully considering the space RETURN FORECAST
market fundamentals. CoStar data show Situs RERC forecasts total returns for
that overall, CRE fundamentals are sturdy, the NCREIF NPI as well as the income
with vacancy near or below their Great components and capital components of
Recession levels across most property total returns. All of Situs RERC’s forecasts
types. Although increased supply across incorporate data from the NCREIF NPI
the sectors will begin to tilt vacancies and are for unleveraged, institutional-
higher, rents should remain relatively grade properties. We present forecasts
stable as demand for space is expected for cash flow and cap rates (income
to remain solid throughout 2018. components) and capital appreciation.
At the end of this section, we present the
Nationally, office vacancy is at its lowest Situs RERC total return forecast for the
level since 2007, according to CoStar. NCREIF NPI.
Rents in the sector have been rising,
driven by job growth in business and
professional services and increasing
demand for tech-ready and co-working
segmented space. The retail sector
continues to face challenges from the
54
Exhibit 5-B by capital appreciation and increasing

Situs RERC Cash Flow, Capital Appreciation prices, while the lower case scenario sees
and Capital Expenditures Forecasts (Base Case Scenario) returns being generated primarily from
income. Because future total returns are
expected to be driven primarily by the
income component, we expect greater
FCFY in the higher case scenario than the
lower case scenario.
INCOME COMPONENT:
CAP RATE FORECAST
NCREIF implied cap rates can be inter-
preted as the current quarter NOI divided
by the current quarter ending market
value. This result is then multiplied by 4 to
get an annual rate. After reaching a low
of 4.46 percent in fourth quarter 2016,
the NCREIF implied cap rate increased in
the first half of 2017 but compressed by
sources Situs RERC, NCREIF, 3Q 2017 10 bps in third quarter 2017. Situs RERC’s
note These forecasts are Situs RERC’s proprietary models based on Situs RERC data and data from the NCREIF base case scenario sees the third quar-
Property Index (NPI) and are for unleveraged, institutional-grade properties. The price change is calculated by
ter’s slight compression as a blip, with cap
adding capital expenditures to capital appreciation/depreciation. Shaded area reflects Situs RERC’s outlook for
the base case scenario for 2018 and 2019. rates increasing to 4.70 percent by the
end of 2018. The lower case scenario sees
the cap rate at almost 5.00 percent by
THE INCOME COMPONENT OF The 1-year trailing FCFY as of third quar-
the end of 2018. The higher case scenario
TOTAL RETURNS: FREE CASH FLOW ter 2017 was 2.89 percent, considerably
has the implied cap rate at 4.55 percent
YIELD (FCFY) FORECAST lower than FCFY’s historical performance,
by the end of 2018.
Per NCREIF, the FCFY is the quarterly net which has been around 4.90 percent
operating income (NOI) minus ordinary since its inception in 1977. FCFY has been
THE CAPITAL COMPONENT
or routine capital expenses, divided by trending downward over recent quarters,
OF TOTAL RETURNS: CAPITAL
the beginning market value in the quarter. and this trend is expected to continue
APPRECIATION FORECAST
It focuses on quarterly net cash flow from (see Exhibit 5-B.) The base case scenario
CRE value can be described in terms of
operations, which accounts for ordinary calls for the downward trend to continue
a price change, which combines capital
or routine capital expenditures. This mea- reaching just below 3.00 percent at the
expenditures and capital returns, or capi-
sure represents additional income beyond end of 2017. We expect FCFY to remain
tal appreciation only. Situs RERC’s capital
rent that investors can expect to receive stable in 2018. The lower case scenario
appreciation forecast provides an alterna-
from investing in the properties at a par- has FCFY returns increasing in 2018,
tive way to examine prices, because a
ticular time and is comparable to stock reaching slightly above 3.00 percent by
significant portion of the run-up in CRE
dividend yield after capital expenditures the end of 2018. The higher case scenario
prices are due to capital improvement
have been paid. sees FCFY decreasing slightly in 2018 to
projects (including leasing activity). Capi-
roughly 2.80 percent. The higher case
tal appreciation has been a primary driver
scenario assumes that returns are driven

Exhibit 5-C of returns post-recession. With cap rates
Situs RERC Total Return Forecast (Base Case Scenario) expected to increase, prices are likely to
start pulling back in the CRE market. Situs
RERC’s base case scenario has capital
appreciation declining to near 0.60 per-
cent by the end of 2018. The lower case
scenario sees capital appreciation falling
to -4.70 percent by the end of 2018. The
higher case scenario sees capital appreci-
ation increasing, reaching approximately
3.90 percent by the end of 2018.
SITUS RERC TOTAL RETURN

FORECAST–CONCLUSION
NCREIF NPI total returns decreased to
1.70 percent in third quarter 2017 from
1.75 percent in second quarter 2017 due
to slight declines in both the income and
sources Situs RERC, NCREIF, 3Q 2017 capital components. Although NCREIF
note The Total Return Forecast is Situs RERC’s proprietary model based on Situs RERC data and data from NPI returns have been strong over recent
the NCREIF Property Index (NPI) and is for unleveraged, institutional-grade properties. Total returns are years, it is important to note that annual
derived from an income component and a capital appreciation/depreciation component. Shaded area returns have been decreasing since 2015.
reflects Situs RERC’s outlook for the base case scenario for 2018 and 2019.
The 1-year trailing NCREIF NPI total return
fell to approximately 8.00 percent in 2016
56
from roughly 13.50 percent in 2015. While to CRE’s recovery. Situs RERC’s conclu- spurring renewed growth in domestic
market fundamentals remain strong, high sions regarding the income compo- manufacturing and warehouse space that
prices are causing investors to broaden nent of total returns have not changed will continue to outpace supply. Prices
their searches for quality investments that much from first quarter 2017. Income is are expected to keep rising for industrial
offer strong yield. Situs RERC’s base case expected to continue being the great- space for at least the near future.
scenario has the NCREIF NPI annual total est driver of total return over the coming The apartment sector, which enjoyed
return decreasing to near 5.40 percent periods. As market prices begin retreating a long run as the dominant performer
by the end of 2018 (see Exhibit 5-C) from their highs, cash flow will continue among major property types, is showing
as income returns drive the majority of to stabilize and capital appreciation will signs of cooling down, as fundamentals
total returns. The lower case scenario has continue to decrease. On the surface, the are weakening. After the vacancy rate
total returns reaching near zero percent US economy seems to be chugging along dropped for 27 straight quarters, it finally
(or slightly negative) by the end of 2018. and cautious optimism over potential tax rose slightly in third quarter 2017 and
The higher case scenario predicts total reform has boosted investment in the is expected to keep inching back up or
returns to increase to near 8.70 percent capital markets. However, the CRE market remain flat in the coming year. A major
by the end of 2018. may be beginning to slow from its peak. cause of the apartment sector’s strength
Market participants should look to take has been the drop in the homeowner-
Capital appreciation has been a primary advantage of high prices and strategically ship rate, which is finally showing signs of
catalyst of cap rate compression since shift their portfolio allocations to better bottoming out and moving back up. This
the recession. However, it is important to capture market potential. would, of course, lead to fewer people
note that much of this growth in capital needing to rent apartments.
appreciation can be attributed to capital PROPERTY TYPES
expenditures. Strength in market funda- The office market is expected to remain a In the hotel sector, which is in the midst of
mentals, such as rent growth, vacancy top investment in 2018 because of its sta- a historic expansion, we expect demand
and employment, have also contributed bility, especially for international investors to outpace supply, ADR growth to stag-
seeking safe places to put their money. nate and cap rates to increase. Foreign
Those foreign investors, however, have investment is slowing down as investors
created a flood of capital and driven up are starting to wonder how long the
prices of top properties in core markets. expansion will last.
Many investors who already own office
real estate have been holding onto their FINAL CONCLUSIONS1
assets, making available properties that As a historically long CRE cycle reaches
much more attractive – and expensive. On its peak, fundamentals have endured.
a risk-return basis, suburban office prop- Additionally, a tight labor market that is
erties can be expected to outperform supporting higher wages and increased
their CBD counterparts because it’s easier consumer spending will help drive
to adapt suburban space to the changing demand for all commercial property
needs of consumers and employees. types and support the income compo-
E-commerce is likely to continue to be nent of total returns. Domestic and for-
a major disruptor in the retail sector in eign policy uncertainty is likely to remain
2018, but this uncertainty does not neces- at the forefront of investors’ minds, lead-
sarily translate into troubles for all prop- ing them to be more concerned about
erty owners or private equity investors. protecting the value of their assets from
Bifurcation in the retail real estate market external forces. Despite the expected
is expected to be more pronounced over decline in total returns over the next year,
the next year, with many Class B and CRE is likely to continue to be a preferred
Class C malls becoming obsolete while asset class because of its favorable return
mixed-use retail space, experiential retail vs. risk profile, offering investors stability
and grocery-anchored neighborhood/ in the risk environment.
community retail are expected to perform
well. However, the shedding of stores
reflects a natural cyclical shift for the sec-
tor, helping to correct the vast oversupply
of retail in the US (as compared to other
countries and discussed in chapter four).
Retail space that can attract high-quality
tenants is expected to survive and thrive
in the Darwinian environment.
The increasing growth in e-commerce,

while a mixed blessing at best for retail
real estate, should continue to bring good
news to the industrial sector in 2018,
1
We present a detailed description of our 2018 economic and real estate expectations in Exhibit 5-D.

Exhibit 5-D
Alternative Economic Scenarios
LOWER CASE SCENARIO: BASE CASE SCENARIO: HIGHER CASE SCENARIO:

DECELERATING GROWTH CONTINUED SLOW GROWTH BETTER GROWTH
US GDP Less than 2.0 percent 2.0 percent to 3.0 percent 3.0 - 4.0 percent or greater
Real Growth
Probability Slightly Likely Most Likely Reasonably Likely
Job growth slows as demand for labor decreases Faster growth from tax reform enhances job creation Persistent gains in jobs push economy to operate be-
and discouraged job seekers leave the workforce further, lowering the unemployment rate and causing yond full employment. Discouraged workers re-enter
or take jobs for which they are overqualified. moderate wage growth. Optimism about economic the workforce resulting in significant workforce.
Employment
Long-term unemployment and wage stagnation conditions fueled employment gains, higher wages.
increase as the labor participation rate flattens or
declines moderately.
A slowing housing market is not buoyed by a Momentum in the housing market slows, but a strong With a stronger job market and increasing wage
strong economy or higher wage growth. Housing economy, employment, and wage growth coupled with growth, home buyers have enough accumulated
affordability becomes an issue for all buyers, par- low interest rates will continue to be positive factors wealth to purchase homes and the housing market
Housing ticularly with rising interest rates and high home for the housing market. Affordability becomes an issue accelerates further. Although new construction
Market prices. In absence of demand, home prices start to as home prices continue to climb up especially for first- increases, supply is unable to meet demand, push-
spiral downward. time buyers. ing prices up even higher and further increasing new
home starts.
Consumer sentiment falls in 2018 causing a Consumer confidence continues to grow in 2018. Ben- Consumers enjoy even further wage growth and
decrease in consumer spending. Wage growth efiting from higher wages, as well as increased tenure begin to spend freely. Personal savings falls as
becomes stagnant, and real disposable incomes for homeowners, consumers continue increasing their consumer confidence rises.
Consumer
fall, at the same time inflation causes prices to spending, in line with newly passed tax reform and low
Spending
increase. Consumers spend less, especially on energy costs.
durable goods. Consumers increase their demand
for cheaper imported goods.
Businesses struggle to keep up with increasing Buoyed by increased demand for goods and services, The stock market continues to reach new highs,
interest rates, and expenses are cut. New hiring along with lower corporate tax rates, business investment signaling improved business sentiment on the back
Business
ceases and wage growth stays flat. increases. Companies make capital investments through of the Trump administration's corporate tax cuts.
Spending
higher spending on information processing and equip-
ment, as well as intellectual property products.
In the wake of substantial tax cuts, the govern- Tax cuts contribute to an increase in the federal deficit, Tax cuts increase federal deficit, but are offset by a
ment fails to curb spending to make up for lost but not to the extent to which growth is hurt. Gov- revised budget that reduces costs of government
Government
tax revenue. Increased government deficit has ernment spending declines in 2018, as nondefense programs.
Spending
negative impact on the economy. expenditures continue to be scaled back and significant
infrastructure spending does not materialize.
Protectionist US policy damages global confi- International trade continues as a mainstay of economic Policies of the administration propel faster growth
dence and weakens international trade. The strong activity. US manufacturers continue to see favorable con- without triggering a trade war. The trade deficit
Trade
dollar limits exports among a global economic ditions. Imports grow more slowly than exports in 2018, narrows as global economies strengthen.
Balance
slowdown, while US consumers rely on cheaper leading to an improvement in the balance of trade.
imports, causing a trade deficit.
Prices, including energy and oil prices, rise as a Inflation is driven by the tight labor market and wage The economy heats up, and inflation nears 3.0 per-
Inflation result of an inflationary environment. growth. Inflation remains slightly above the FOMC's 2.0 cent. Bonds become less appealing, as their prices
percent target. decrease, interest rates go up.
Current administration fails to reach agreement on Rates increase steadily through 2018 and 2019. FOMC The US economy accelerates more than expected.
policies. Global political and economic uncertain- will continue winding down the balance sheet gradually Successful tax reform fuels growth pushing up
ties push investors out of other asset classes to enough to avoid disrupting markets. The tight labor inflation. The FOMC pursues more aggressive path
Interest
Treasurys in flight to safety. The FOMC delays market will provide additional boost to the economy. of monetary tightening driving the Treasury rate to
Rates
additional rate increases and slows its reversal of The 10-year Treasury yield rate rises gradually to high-2 upper 3 percent.
QE. The 10-year Treasury Yield rate declines to percent range.
around 2 percent.
The 10-year Treasury rate increases to combat Cap rates flatten or reverse course, as CRE returns rely Fundamentals improve for all property types. Space
rising inflation. Financing becomes very challeng- more heavily on the income component and less on in all sectors particularly suburban office, malls,
ing and defaults rise at faster pace. Sales volume appreciation. Commercial real estate investment volume and obsolete in-fill warehouses, are renovated and
and property prices drop significantly, and cap continues to decline, which provides reasons for concern converted to become more desirable. Transaction
rates increase at a faster pace. The retail sector about the current real estate cycle’s timing and duration. volume exceeds 2015 levels, with pricing reaching
in particular suffers due to a decline in consumer Markets with strong fundamentals that can support new highs. Prices in most markets reach or surpass
Commercial spending. Vacancy rates start to increase across income growth preserve value for investors. Tax reform pre-recession era high. Cap rates continue to com-
Real Estate most property types, specifically in the retail and interest rate hikes do not have a large harmful effect press. Although unlikely, the risk of forming another
sector, with additional mall/store closings. on real estate, given the point in the cycle and already CRE bubble increases.
being baked into the market calculus for pricing. E-
commerce continues to be a boon to the industrial sector
but also a source of volatility for the retail sector. The
office sector continues its transformation, as the apart-
ment sector tries to shake off the excess supply.
sources BLS, BEA, The Conference Board, RCA, NCREIF, NAR,

Situs RERC, Deloitte, January 2018.
note These are not the only scenarios that are possible, and there will usually be
©2018 Deloitte Development LLC, National Association of REALTORS®, 2018 Situs RERC. differences between the forecasted and actual results because events and circum-
58
All Rights Reserved. stances frequently do not occur as expected, and those differences may be material.
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EXPECTATIONS & MARKET REALITIES IN REAL ESTATE 2018
DELOITTE / NATIONAL ASSOCIATION OF REALTORS®/ SITUS RERC

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EXPECTATIONS & MARKET REALITIES IN REAL ESTATE

No part of this publication may be reproduced in any form

Expectations & Market Realities in Real Estate 2018 is published by

Deloitte Development LLC

NATIONAL ASSOCIATION OF REALTORS®

Disclaimer: This report is designed to provide general information in

Situs RERC, Deloitte and the National Association of

The US economy, building on the momentum of an often

Due to the continued rise of e-commerce, we expect another

We would like to extend our gratitude to all who contrib-

Kenneth P. Riggs, Jr., CFA, CRE, MAI, FRICS

Kenneth P. Riggs, Jr., CFA, CRE, MAI, FRICS

Lawrence Yun, PhD Chief Economist

Todd J. Dunlap, MAI, MRICS, Senior Manager

Kenneth W. Kapecki, CRE, FRICS, MAI, Managing Director

Andy J. Miller, Senior Manager

Jen Rasmussen, PhD, AVP, Editor-in-Chief

George Ratiu, Managing Director

Morgan Westpfahl, Director

Janey Graveman, Graphic Designer

Joseph Henry, Analyst

Surabhi Kejriwal, Research Leader, Real Estate

Matt Lamers, Senior Consultant

Saurabh Mahajan, Manager, Real Estate

Noel Nathan, Intern

Neeraj Sahjwani, Senior Analyst, Real Estate

Shradha Shrestha, Associate

Nellie Tiggelaar, Consultant

STABILITY IN A RISK ENVIRONMENT........................................................................................................................................................................................................................... 9

3 THE CAPITAL MARKETS

4 THE PROPERTY MARKETS

5 SUMMARY & OUTLOOK

STABILITY IN A RISK ENVIRONMENT

President Trump also signed a number of executive orders in 2017 that

Amid the volatility, economic indicators throughout the year gradually

Despite the political chaos, investors gravitated toward the financial

Long-term return averages, however, paint a different picture of the

1-Year 3-Year 5-Year 10-Year 15-Year

Consumer Price Index1 1.10% 2.23% 1.23% 1.30% 1.68% 2.08%

10-Year Treasury Bond2 2.33% 2.27% 2.09% 2.21% 2.63% 3.21%

NASDAQ Composite4 21.06% 24.12% 13.19% 15.90% 9.20% 12.12%

NYSE Composite4 8.79% 15.97% 4.49% 8.15% 1.98% 6.56%

S&P 5003 14.24% 18.61% 10.81% 14.22% 7.43% 10.04%

NCREIF NPI5 5.15% 6.98% 9.93% 10.45% 6.27% 9.09%

NCREIF NFI ODCE5 4.95% 6.58% 9.52% 10.13% 6.03% 8.85%

As presented in our 2017 Expectations & About 47 percent of the respondents

THE 2017 YEAR-END TOTAL Compared to

WAS 7.0 PERCENT DUE TO

STRONGER-THAN-EXPECTED ability would

Most Favorable Least Favorable

2011 2012 2013 2014 2015 2016 2017

Office 17.5 % 13.1% 12.3% 13.0% 16.0% 14.0% 11.5%

Multifamily 29.2 % 45.8% 46.8% 45.5% 35.5% 40.7% 46.8%

Retail 9.4 % 8.4% 8.4% 6.5% 8.3% 7.7% 6.8%

Hotel 4.7 % 3.7% 3.2% 4.4% 6.0% 6.9% 3.8%

Not Sure 27.4 % 19.1% 18.2% 18.2% 21.4% 20.3% 17.1%

More stress -15% to -2% Minimal change -2% to +2%

While economic growth in the EU was broad-based, momentum gains

Asian economies continued moving with a solid upward momentum

In the Americas, economic trends underscored a rising global tide.