Expectations and Market Realities in Real Estate in 2015 02-06-2015

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E X P E C T A T I O N S & M A R K E T R E A L I T I E S I N R E A L E S T A T E 2 0 1 5

SCALING NEW HEIGHTS

THE ECONOMY

The Economy Accelerates

THE CAPITAL MARKETS

Capital Waters Run Deep

THE PROPERTY MARKETS

Strengthening Fundamentals

SUMMARY & OUTLOOKLooking Ahead to 2015


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Expectations & Market Realities in Real Estate Scaling New Heights

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Disclaimer: This report is designed to provide general information in regard to the subject matter covered. It is sold with the understanding that the authors

of this report are not engaged in rendering legal or accounting services. This report does not constitute an offer to sell or a solicitation of an offer to buy anysecurities, and the authors of this report advise that no statement in this report is to be construed as a recommendation to make any real estate investment

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as a whole, not as support for any particular real estate investment or security. Neither Situs, RERC LLC, Deloitte, nor NATIONAL ASSOCIATION OF REALTORS(NAR), nor any of their respective directors, officers, and employees warrant as to the accuracy of or assume any liability for the information contained herein.

As used in this document, Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its networkof member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal

structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure

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E X P E C T A T I O N S & M A R K E T R E A L I T I E S I N R E A L E S T A T E 2 0 1 5

SCALING NEW HEIGHTSDELOIT TE | NATIONAL ASSOCI ATION OF REALTORS | RERC | S ITUS


4/702015 SITUS, RERC LLC, DELOITTE DEVELOPMENT LLC, NATIONAL ASSOCIATION OF REALTORS. ALL RIGHTS RESERVED. | 4

EXPECTATIONS & MARKET REALITI ES IN REAL ESTATE 2015 | SCALIN G NEW HEIGHTS

SPONSORING FIRMS

Situs & RERC

Situs is the premier, global provider of end-to-end commercial real estate and loan advisory services and inte-grated solutions, offering customized services to leading financial institutions, investors, owners, and developers.

We offer a wide array of services, including enterprise and process improvement, capital markets and commercialreal estate advisory, third-party business solutions, primary and special servicing, and creative staffing solutions.In 2014, Situs acquired Real Estate Research Corporation (RERC), a nationally-recognized provider of valuationmanagement and fiduciary services, appraisal and litigation services, and research, data analytics, and publica-tions. ogether, the Situs and RERC team of more than 600 highly-skilled professionals provide an expanded suiteof services and solutions to its clients, including both debt- and equity-side focused expertise, superior commer-cial real estate knowledge and capabilities, and unwavering commitment to client needs. We have proudly con-ducted over $1 trillion in commercial real estate evaluations, resolved over $20 billion in distressed assets, beenthe special servicer on over $100 billion of commercial real estate loans, and provided independent fiduciary and

valuation management services for the multi-billion-dollar real estate accounts of some of the worlds leading pen-

sion funds and insurance companies.

Deloitte

Deloitte*is a recognized leader in providing audit, tax, consulting, and financial advisory services to thereal estate industry. Our clients include top REIs, private equity investors, developers, property man-agers, lenders, brokerage firms, investment managers, pension funds, and leading homebuilding andengineering & construction companies. Deloitte Real Estate provides an integrated approach to assist-ing clients enhance property, portfolio, and enterprise value. We customize our services in ways to fitthe specific needs of each player in a real estate transaction, from owners to investment advisors, fromproperty management and leasing operators to insurance companies. Our multi-disciplinary approachallows us to provide regional, national and global services to our clients. Our real estate practice is recog-nized for bringing together teams with diverse experience and knowledge to provide customized solu-tions for all clients. Deloitte Real Estate in the United States comprises over 1,400 professionals support-ing real estate clients out of offices in 50 cities; key locations include Atlanta, Boston, Chicago, Dallas,Denver, Houston, Los Angeles, Miami, New York, San Francisco, and Washington, D.C. Deloittes globalReal Estate Services industry sector includes over 8,000 professionals located in excess of 40 countries.

NATIONAL ASSOCIATION OF REALTORS

Te NAIONAL ASSOCIAION of REALORS, Te Voice for Real Estate, is Americas largest trade association,representing 1.0 million members involved in all aspects of the residential and commercial real estate industries.NAR membership includes brokers, salespeople, property managers, appraisers, counselors and others. Approxi-mately 78,000 NAR and institute affiliate members specialize in commercial brokerage and related services, and anadditional 232,000 members offer commercial real estate services as a secondary business. Te term REALOR is aregistered collective membership mark that identifies a real estate professional who is a member of the NAIONAL

ASSOCIAION of REALORS and subscribes to its strict Code of Ethics. Working for Americas property owners, theNational Association provides a facility for professional development, research and exchange of information among itsmembers and to the public and government for the purpose of preserving the free enterprise system and the right toown real property.

&

*As used in this document, Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network ofmember firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure ofDeloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP andits subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.




FOREWORD

January 2015

Dear Readers,

As 2015 gets underway, many investors are more optimistic than they have been in years. Economic grow th has been increas-ing, job growt h has been improving, and consumers have been given a boost as gasoline prices have dipped nationwide. Compared to the markets and financial systems in other developed countries, the U.S. economy looks generally healthy.

With respect to commercial real estate investment, interest rates are still low and fundamentals continue to improve. Volumeand pricing have been increasing, especially for high-quality properties in the coastal markets, but we have also seen highvalues and prices in more secondary and tertiary markets. Ret urns in the form of both income and appreciation are expected

to remain quite attractive in 2015 compared with many investment alternatives.

Wethe National Association of REALORS (NAR), Deloitte, RERC LLC, and Sit us (RERCs parent company), which is notedhereafter as Situs RERCexpect these trends to continue. In fact, we expect commercial real estate prices and values to pos-sibly increase even more during 2015, given the relative expected returns, the general transparency of commercial real estatein that it is relatively easy to understand, and the perceived safety of this asset class compared with many investment alternatives. As such, this issue ofExpectations & Market Realities in Real Estatehas been entitled Scaling New Heights.

Tank you to all who have contributed to our research-based annual forecast report, including our research and data provid-ers, economists, analysts, survey respondents, reviewers, and business associates and colleagues. We appreciate your w illing-ness to share your insights, information, and observations forExpectations & Market Realities in Real Estate 2015Scaling

New Heights. We also thank youour clients, subscribers, and consultantsfor your continued interest and support. We hopeyou find our report of value.

Sincerely,

Lawrence Yun, PhD

Sr. Vice President, Chief EconomistNATIONAL ASSOCIATION OF REALTORS

Matthew G. Kimmel, CRE, FRICS, MAI

Principal & US Real Estate Services LeaderDeloitte Transactions and Business Analytics LLP

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

PresidentRERC, A Situs Company




ACKNOWLEDGEMENTS

SPONSORING FIRMS & CHAIRS

Matthew G. Kimmel, CRE , FRICS, MAIPrincipal, Deloitte Transactions and Business Analytics LLP

Kenneth P. Riggs, Jr., CFA, CRE, FRICS President of RERC, A Situs Company

Lawrence Yun, PhD Chief Economist, NATIONAL ASSOCIATION OF REALTORS

CONTRIBUTING AUTHORS

Barbara Bush, Director RERC

Todd J. Dunlap, MAI, MRICS, Senior Manager

Deloitte Transactions and Business Analytics LLPKenneth W. Kapecki, CRE, FRICS, MAI, Director

Deloitte Transactions and Business Analytics LLPConstantine (Tino) Korologos, CRE, MAI, MRICS, Managing Director

Situs

Lindsey Kuhlmann, Analyst RERCSaurabh Mahajan, Research Leader, Real Estate

Deloitte Services India Pvt. Ltd.

Andy J. Miller, Manager Deloitte Transactions and Business Analytics LLP

George Ratiu, Director NATIONAL ASSOCIATION OF REALTORSAaron Riggs, Analyst RERC

Jed Smith, PhD, Managing Director

NATIONAL ASSOCIATION OF REALTORSSurabhi Sheth, Assistant Manager, Real Estate

Deloitte Services India Pvt. Ltd.

Ye Thway, Manager RERCMorgan Westpfahl, Director RERC

Lev Yagudayev, MAI, Director RERC

DESIGN & LAYOUT

Jeff Carr, Manager RERC

OTHER DISTINGUISHED CONTRIBUTORS

Victor Calanog, PhD Reis, Inc.

Ronald Johnsey Axiometrics, Inc.

Robert Mandelbaum PKF Hospitality ResearchRobert M. White Real Capital Analytics

R. Mark Woodworth PKF Hospitality Research




CONTENTS

1 | INTRODUCTION

Scaling New Heights ..................................................................................................................................................................................8

2 | THE ECONOMY

Te Economy Accelerates .......................................................................................................................................................................12

3 | THE CAPITAL MARKETS

Capital Waters Run Deep ....................................................................................................................................................................... 26

4 | THE PROPERTY MARKETS

Strengthening Fundamentals ................................................................................................................................................................35

5 | SUMMARY & OUTLOOK

Looking Ahead to 2015 ........................................................................................................................................................................... 58

SPONSORING FIRMS

....................................................................................................................................................................................................................67




1 INTRODUCTIONSCALING NEW HEIGHTS




SCALING NEW HEIGHTS

In preparing the 2015 issue of Expecta-

tions & Market Realities in Real Estate,weRERC and Situs (known herein asSitus RERC), Deloitte, and the NationalAssociation of REALORS (NAR)looked back at 2014 to review and exam-ine major world events as they affectedthe U.S. economy, capital markets, andcommercial real estate markets.

Te year 2014 began calmly with thesmooth transition of Janet Yellen as thenew chair of the Board of Governors ofthe Federal Reserve. She has contin-

ued to carry out the accommodativemonetary policies originally enacted byformer Chair Ben Bernanke. However,it was not long into 2014 before worldevents took center stage. erritorialdisputes between Russia and its neigh-bors, along with threats from the newly-formed Islamic State of Iraq and Syria(ISIS) dominated newscasts. Coverageof new acts of terrorism and fears of theEbola virus spreading to the U.S. andEurope worried investors and the gen-eral public alike. Weaknesses in mostof the European economies, as well asin China and Japan, were reported, justas economic growth in the U.S. beganto spike. Many investorsboth foreignand domesticbecame increasinglyattracted to the perceived relative safetyof the U.S. economy and other safe-haven investments.

As the year 2014 began to wind down,the Federal Reserve concluded itspurchases of bonds and securities

as planned. Employment growthincreased substantially throughoutthe year, and the unemployment ratecontinued to fall, dropping to 5.6 per-cent in December 2014 per the Bureauof Labor Statistics (BLS). Althoughwages remained stagnant and infla-tion remained below the FederalReserves target range of 2 percent, themajor stock market indices reached

new highs in December, with the Dow

Jones Industrial Average (DJIA) toppingthe 18,000-point mark and the S&P 500topping 2,000. Declining oil prices mayhave caused stock market returns to dipby year-end 2014, but consumers werebuoyed by lower costs for fuel, as gaso-line prices dropped to around $2 pergallon in most states.

With respect to commercial real estate,interest rates remained low, and vol-ume and prices increased in 2014for high-quality properties. We saw

new highs for many property prices,especially in the coastal markets likeNew York City, Boston, Washington,DC, and San Francisco. However, wehave also seen high prices and strongtotal return performance occurringin many secondary and tertiary mar-kets, as discussed herein. We expectthese trends to continue in 2015, as

outlined in Expectations & Marke

Realities in Real Estate 2015ScalingNew Heights.

Looking Ahead to 2015

Despite being a record $18 trillion indebt, our collective view for 2015 is thatthe U.S. economy is healthier than it wasa year ago. However, the economies inmost of the rest of the developed worldand the major emerging markets haveslowed significantly. Given the economic weaknesses worldwide, along

with continued terrorism throughouthe Middle East and recent terror cam-paigns in Paris and other locationsin Europe, the perceived comparative safety in U.S. markets has gainedadditional importance. Apparent safeharbor investments like commerciareal estate are increasingly attractiveto many, especially when interest rates




are low (even if they increase slightlyin 2015, we expect them to remain lowon a historical basis). Te demand forhigh-quality commercial real estate hascaused property values and prices toclimb to new heights.

As such, the 104-story One World radeCenter, an iconic symbol of Americanrenewal and hope that is redefiningLower Manhattans New York skyline,was selected for the front cover ofExpec-tations & Market Realities in Real

Estate 2015Scaling New Heights.1Not only is One World rade Center theWestern Hemispheres tallest building,it also represents:

n Te worlds largest economy and

the improvement in the recoverythat we are witnessing.

n Te record-high levels of financialassets available for investing.

n Te high returns we have seen inthe stock market and some otherasset classes.

n Still rising prices and values forcommercial real estate.

n Americas spirit. As the nation andNew York City continue to recoverfrom the terror attacks on Sept.11, 2001, the spire atop this build-ing brought the height of this sky-scraper to a symbolic 1,776 feet.2

Going forward, the primary concernsof many investors include how longthe short-term federal funds rate willremain in the 0 to 1/4 percent range, andwhen will long-term interest rates begin

to increase. According to the FederalOpen Market Committees (FOMCs)minutes from their December 16-17,2014 meeting, the FOMC reaffirmedits view that the current 0 to 1/4 percenttarget range for the federal funds rate

remains appropriate. In determininghow long to maintain this target range,the Committee will assess progressboth realized and expectedtowardits objectives of maximum employ-ment and 2-percent inflation. Tisassessment will take into account awide range of information, includingmeasures of labor market conditions,indicators of inflation pressures andinflation expectations, and readingson financial developments. Based onits current assessment, the Committeejudges that it can be patient in begin-ning to normalize the stance of mon-etary policy. Te Committee sees thisguidance as consistent with its previousstatement that it likely will be appropri-ate to maintain the 0 to 1/4 percent tar-get range for the federal funds rate for aconsiderable time.

Opinions vary, but according to NARs

outlook (detailed in Chapter 2), the fed-eral funds rate is forecasted to remainat 0.1 percent in first quarter 2015, andthen begin to increase to 0.3 percent insecond quarter 2015, to 0.5 percent inthird quarter 2015, and to 0.8 percent

in fourth quarter 2015. Further, NARforecasts 10-year reasury yield ratesto increase to 2.4 percent in first quar-ter 2015, and rise to 2.6 percent in sec-ond quarter 2015, to 3.0 percent in t hirdquarter 2015, and to 3.5 percent infourth quarter 2015.

Te economic situation in Europe wilbear watching in 2015. At present, iappears that the European CentraBank (ECB) plans to follow the quantita-tive easing policies implemented in theU.S., UK, and Japan, and will purchasea total of 60 billion ($69 billion) inassets each month beginning in March2015 and extending through Septembe2016, stated Mario Draghi, ECB president, in an effort to combat stagnationand ultralow inflation.

Expectations & Market Realitiesin Real Estate 2015Scaling New

Heights

Despite the challenges and uncertainties in the economy and capital mar-kets, commercial real estate invest-ments generally produced solid returns

One World rade Center, an architectural and engineering marvel, was designed by renowned architect David Childs of Skidmore, Owings, and Merr ill, LLP

Port Authority of New York and New Jersey (www.panynj.gov).

Ibid.




in 2014. Based on our collective analy-sis, we expect this trend to continue in2015 and are cautiously optimistic thatcommercial real estate fundamentalswill continue to slowly improve andthat values will keep up with escalat-

ing prices, even at the new heights weare seeing. As noted in Expectations &Market Realities in Real Estate 2015Scaling New Heights, total expectedreturns on a risk-adjusted return basisappear reasonable in the year ahead.

Chapter 2 of this report notes that as2015 gets underway, the U.S. economyis improving and is basically normalin terms of growth. NARs economicforecast for 2015 projects gross domes-tic product (GDP) to approach a 3-per-

cent real growth level in the foreseeablefuture and an acceleration of currentfavorable economic trends.

However, the chapter also notes the fol-lowing risks to economic growth:

n Significant numbers of peoplecontinue to be unemployed orunder-employed.

n Wage/income growth is stagnantfor the majority of households.

n Housing market growth continuesto be slow.

n Foreign economic slowdowns arecontinuing.

n Credit availability remains exces-sively tight.

n College student debt remains high,and household formation is low.

We examine the capital markets inChapter 3of this report, noting that theinvestment world is flush with capitaland that the U.S. commercial real estatesector continues to attract much of thatcapital (approximately $5.06 trillion3),as graphed in the estimated equity and

debt totals included in the report. Infact, the availability (amount) and disci-pline (underwriting standards) of capi-tal resemble the trends leading up tothe Great Recession, according to SitusRERCs historical analysis. Although

we do not expect a repeat of the creditcrisis of 2006 and 2007, according toCommercial Mortgage Alert, the issu-ance of commercial mortgage-backedsecurities (CMBS) in 2014 was similarto issuance in 2004, and many inves-tors expect issuance to increase duringthe next few years similarly to the pre-credit crisis era, especially if underwrit-ing standards continue to loosen.

Further, interest rates will likely remainlow through 2015. Even if the Federal

Reserve begins to raise short-termrates, any increases are expected to besmall and gradual. In addition, givenlow inflation and other economic risks,some market participants have beendowngrading their expectations aboutrisk-free rates and the timing as to whenthe Federal Reserve will increase thefederal funds rate. Capitalization ratesare expected to continue to compresson a broad market basis, as long asinterest rates remain low.

In Chapter 4, we offer our highlightsand expectations for the five major

property sectorsthe office, indus-trial, retail, apartment, and hotel mar-kets. Our analysis examines volumepricing, capitalization rates, vacancy/occupancy rates, absorption and com-pletions, and rental rates/revenues for

each of the property types. On a yearlybasis, commercial real estate invest-ments rose across all property typesexcept for the apartment sector, reach-ing $288.5 billion in transaction volumeby third quarter 2014, according to ReaCapital Analytics. Prices also increasedAs fundamentals are expected to continue strengthening, commercial assetsremain an attractive investment optionfor many investors.

Finally, in Chapter 5, we offer a sum-

mary of the highlights of the report andour collective outlook for 2015. Te year2015 will be an interesting period forinvestors, and we expect commerciareal estate values to continue to increaseslightly or to remain about the sameas currently. Per Situs RERCs analy-sis, it appears that broad market pricesand values have room to increase forapproximately 12 to 18 months, assum-ing that the economy and capital mar-kets continue to function as expectedas outlined in our alternative economicscenarios for 2015.

Situs RERC est imate, December 2014.




2 THE ECONOMYTHE ECONOMY ACCELERATES




THE ECONOMY ACCELERATES

Alt hough the Great Recession offi-

cially ended more than 5 years ago,according to the National Bureau ofEconomic Research (NBER), the after-effects of the recession lingered formuch longer.4 Until very recently, thepost-recession economy experiencedsignificant challenges, including highunemployment, slow GDP growth,declining family incomes, decreasedcredit availability, and high levels ofrisk aversion. For example, employ-ment growth, which is a strong mea-sure of economic wellbeing for most

people, was subpar after the GreatRecession compared to the employ-ment growth after other recessions.Exhibit 2-1 compares the employmentlevels after the Great Recession incomparison to growth after a numberof other recessions (a similar conclu-sion holds for GDP).

However, in the second half of 2014and thus far in 2015, there have beenincreasing indications that the econ-omy is improving, and as such, NARforecasts GDP to approach a 3 per-cent real growth level in the foresee-able future. Tis forecast is a welcomechange from the doom and gloomoutlook that has accompanied much

of the countrys economic activityduring the past few years.

Tere are, however, two downsiderisks which have been factored intothe short-term forecast, but whichstill need to be addressed in the longrun. First, as the Federal Reserveends quantitative easing, manag-ing financial policies in order to

avoid negatively impacting economicgrowth will be important. Secondmany families have not participatedin the increased prosperity. Salariesand wages in real terms have in manycases been constant or decliningTis phenomenon is not well under-stood, but it is important and shouldbe addressed. Given the circular flowof the economy, some improvementin incomes, other things being equalwould likely help to spur economicgrowth.

Overall, NARs economic forecast for2015 projects an acceleration of cur-

rent favorable economic trends. Alforecasts are filled wit h uncertaintiesso the risks are highlighted herein. Onbalance, the uncertainties and risksappear to be on the upsidethat isthe economy may actually performbetter than expected as uncertaintiesare resolved.

92

96

100

104

108

112

116

8478726660544842363024181260-6-12-18-24

Index

1948-Nov

1973-Nov

1980-Jan

1990-Jul

2001-Mar

2007-Dec

Months

Exhibit 2-1. Comparison of Employment Growth After Recessions

Source: BLS, December 9, 2014.

Te Great Recession lasted f rom December 2007 to June 2009, according to NBER.




EFFECTS OF THE GREAT RECESSION

Te Great Recession of December2007 through June 2009 had a majornegative impact on incomes, wealth,and confidence. A comparison of the

actual GDP level as of third quarter2014 with what it would have been ifthe previous GDP growth rate5 hadcontinued absent a recession showsthat GDP was approximately $2.5 tril-lion lower than it would otherwisehave been (see Exhibit 2-2), per theBureau of Economic Analysis (BEA).

Alt hough the Great Recession hasbeen officially over for more than 5years, its impact cont inues to be felt ina variety of ways:

n Te growth of personal income was

interrupted, as depicted in Exhibit2-3. Having risen at a 2009 con-stant dollar annual rate of approxi-mately 2.5 percent in the 8 yearsprior to December 2007,6 personalincome fell a total of 3 percent

0

5

10

15

20

25

3Q201

4

3Q201

2

3Q201

0

3Q200

8

3Q200

6

3Q200

4

3Q200

2

3Q200

0

3Q199

8

3Q199

6

3Q199

4

3Q199

2

3Q199

0

$T

rillions

GDP Actual

GDP Trend

Exhibit 2-2. $2.5 Trillion Missing GDP from Great Recession

Sources: BEA, Haver Analytics, 3q 2014.

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Haver Analytics. GDP growth computed as quarterly growth rate 1990 Q1 through 2008

Q3.

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Haver Analytics. Constant dollar PCE computed on basis of PCE Chain Price Index,

2009 =100.

6,000

8,000

10,000

12,000

14,000

16,000

Nov

-14

Nov

-12

Nov

-10

Nov

-08

Nov

-06

Nov

-04

Nov

-02

Nov

-00

$

Billions

Personal Income

Personal Income, 2009$

Exhibit 2-3. Personal Income: Actual and Constant Dollar

Sources: BEA, Haver Analytics, September 2014.




between December 2007 and June2009, per the BEA. Growth sinceJune 2009 has been at a rate of 2.3percent per year from the post-recession base, lower than it wouldotherwise have been.

n Real median family income hasbeen declining since 1999, accord-ing to the Census Bureau, and thedecline became increasingly seri-ous during the Great Recession, asshown in Exhibit 2-4.7

n Between fourth quarter 2007 andsecond quarter 2009, the totalvalue of household assets mea-sured in terms of real estate andfinancial assets8 declined by 15

percent, a total of $10.6 trillion,per the Federal Reserve. In com-parison, between 2000 and 2007,assets rose at approximately 7percent per year, but much of thegain was in the stock market. Formany families, the major assetis the value of the home, which

declined during the Great Reces-sion but has recovered to a signifi-cant degree, as demonstrated inExhibit 2-5.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

2013

2003

1993

1983

1973

1963

$Dollars

2013 Constant Dollars

Current Dollars

Exhibit 2-4. Median Family Income

Sources: U.S. Census Bureau, Haver Analytics, 2014.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

2Q201

4

4Q201

1

2Q200

9

4Q200

6

2Q200

4

4Q200

1

2Q199

9

4Q199

6

2Q199

4

4Q199

1

2Q198

9

4Q198

6

2Q198

4

4Q198

1

2Q197

9

4Q197

6

2Q197

4

4Q197

1

2Q196

9

4Q196

6

2Q196

4

4Q196

1

$

Billions

Financial Assets

Real Estate

Owners Equity

Exhibit 2-5. Household Assets

Sources: Federal Reserve System, Financial Accounts of the United States, Haver Analytics, 2q 2014.

U.S. Department of Commerce, Bureau of the Census, Current Population Reports, Serie s P-60. Income, Poverty and Health Insurance in the United States,

Haver Analytics.

Federal Reserve System, Financial Accounts of the United States, Haver Analytics. Household data also include non-profits.




n As reflected in Exhibit 2-6, theGreat Recession also negativelyimpacted consumer confidence,as measured by Te ConferenceBoard.9

n Finally, unemployment rates dur-ing the Great Recession, as shownin Exhibit 2-7, were at their highestin 25 years, per the BLS.10

In summary, the Great Recession wasassociated with lower incomes, higherunemployment, decreased consumerconfidence, lost wealth, and slowergrowth. Terefore, it is not surprisingthat the post-recession recovery wasinitially weak as the nations economic

decision makersconsumers, busi-nesses, and investorsrebuilt theirfinancial capabilities. In addition, theGreat Recession increased the riskaversion felt by the major economic

participants. Banks, for exampledecreased credit availability. Industrydecreased investment expendituresGovernments decreased spendingConsumers focused on deleveraging.

0

20

40

60

80

100

120

140

160

Oct

2014

Oct

2012

Oct

2010

Oct

2008

Oct

2006

Oct

2004

Oct

2002

Oct

2000

Oct

1998

Oct

1996

Oct

1994

Oct

1992

Oct

1990

Oct

1988

Oct

1986

Oct

1984

Oct

1982

Oct

1980

Oct

1978

Index

Exhibit 2-6. Consumer Confidence

Sources: The Conference Board, Haver Analytics, October 2014.

0

2

4

6

8

10

12

Jan20

14

Jan20

10

Jan20

06

Jan20

02

Jan19

98

Jan19

94

Jan19

90

Jan19

86

Jan19

82

Jan19

78

Jan19

74

Jan19

70

Percent

Exhibit 2-7. Unemployment Rate

Sources: BLS, Haver Analytics, October 2014.

Te Conference Board, 1985=100, seasonally-adjusted.

BLS, Household Survey Data, Haver Analytics; data current through October 2014.




THE ECONOMIC OUTLOOK2015AND BEYOND

Te economys rate of expansion, ini-tially slower than would normallyhave been expected after a recession,

seems to have finally increased:n Consumer confidence:Consumer

confidence recovered from a lowof 25 in February 2009 to 92.6 inDecember 2014. However, thislevel is still below 100, which isconsidered the normal level dur-ing robust expansions.

n Unemployment rate: Te unem-ployment rate has declined,although the projected 5.6-per-

cent unemployment rate for 2015is higher than the 5-percent ratethat would have been generallyregarded as normal a few yearsago.

n Economic Growth: Te economyhas finally started to show somesigns of acceleration, althoughthe GDP growth rate in recentyears has been disappointinglylow. NARs projected 3.1-percentgrowth rate for 2015 is better thanexperienced in the past 2 years.

n Employment:Te level of employ-ment is expected to improve in2015, growing at a 2-percent rate.As of November 2014, the unem-ployment rate was 5.8 percent, withapproximately 9.1 million workersreported as unemployed. Of the147.3 million workers employed,6.9 million worked part-time dueto economic reasons, and labor

force participation declined fromalmost 67 percent to slightly under63 percent. At current job growthrates, NAR projects the economyto achieve an unemployment rateof 5.5 percent in late 2015.

n Part-time employment:Part-timeemployment for economic rea-sons has grown to approximately7 mill ion workers, which accountsfor approximately 5 percent ofestablishment-level employees,

according to the BEA. Tis com-pares to an average of approxi-mately 3 percent of employeeswho worked part-time in the 1999to 2007 time period, as shown inExhibit 2-8.11

n Inflation: NAR projects inflationat 1.2 percent for 2014, 2.0 percentfor 2015, and 3.2 percent for 2016With substantial slack in the labormarket and dormant wage growthNAR projects inflation levels to

continue to be relatively low in2015.

Te NAR forecast shows an outlook forcontinued economic expansion, withreal economic growth expected to

0

1

2

3

4

5

6

7

8

Sept

2014

Sept

2013

Sept

2012

Sept

2011

Sept

2010

Sept

2009

Sept

2008

Sept

2007

Sept

2006

Sept

2005

Sept

2004

Sept

2003

Sept

2002

Sept

2001

Sept

2000

Percent

Exhibit 2-8. Percent of Workers Who Are Part-Time for Economic Reasons

Sources: BEA, Haver Analytics, November 2014.

An additional 20 million workers were part-time workers as of November 2014 for non-economic reasons, according to the BLS Household Survey.




return to approximately 3 percent in2015, as shown in Exhibit 2-9.

GDP BY ECONOMIC SECTOR

A review of GDP by sector providesinsight on the risks and uncertain-ties associated with the forecast. Tedownside risks of a no-growth econ-omy or a recession in the near futureappear to be minimal, but slower-than-normal growth appears likely.

Using the standard macroeconomicformula for GDP, analysis of the spe-cific components provides insight onthe future course of the economy:

Consumption

Personal consumption expenditurescomprise approximately 67 percent

of GDP, according to the BEA.12 Anychange in consumption will have asubstantial impact on GDP levelsOnce the Great Recession began, thegrowth of consumption lagged rela-tive to previous trends. If consump-

tion had continued to increase atprevious rates absent the Great Reces-sion, personal consumption expendi-tures would have been $12.3 trillion in2009 constant dollars as of third quar-ter 2014 rather than the actual $11 tril-lion, as depicted in E xhibit 2-10.

U.S. Department of Commerce, BEA, Haver Analytics.

Exhibit 2-9. NAR Economic Outlook/Forecast

Sources: GDP Growth rate: BEA/Haver Analytics, Nonfarm Payroll Employment: BLS/Haver Analytics, Consumer Prices: BLS/Haver Analytics, Federal Funds rate (effective): FRB, TableH.15/Haver Analytics, 3-month T-bill rate: FRB, Table H.15/Haver Analytics, Bank prime loan rate: FRB, Domestic Interest Rates Updated Before FRB Publication/Haver Analytics,Moodys Corporate AAA Corporate Bond Yield: FRB, Table H.15/Haver Analytics, 10-yr Treasury Note Yield at Constant Maturity: FRB, Table H.15/Haver Analytics, 30- yr Treasury NoteYield at Constant Maturit y: FRB, Table H.15/Haver Analytics, Januar y 2015.

Growth

Rate Real

GDP(percent)

Nonfarm

Payroll

Empl.

(percent

growth)

Consumer

Prices

(percentgrowth)

Percent

Unempl.

Interest Rates (Percent)

Fed

Funds

Rate

3-moT Bill

PrimeRate

Corp.

AAA

bond

10-yr

Govt.

Bond

30-yr

Govt.

Bond

1Q 2013 2.7 1.9 1.6 7.7 0.1 0.1 3.3 3.9 2.0 3.1

2Q 2013 1.8 1.8 1.4 7.5 0.1 0.1 3.3 4.0 2.0 3.1

3Q 2013 4.5 1.6 1.6 7.2 0.1 0.1 3.3 4.5 2.7 3.7

4Q 2013 3.5 1.8 1.2 7.0 0.1 0.1 3.3 4.6 2.8 3.8

1Q 2014 -2.1 1.5 1.9 6.7 0.1 0.1 3.3 4.4 2.8 3.7

2Q 2014 4.6 2.1 2.0 6.2 0.1 0.1 3.3 4.2 2.6 3.4

3Q 2014 5.0 2.4 1.1 6.1 0.1 0.1 3.3 4.1 2.5 3.3

4Q 2014F 2.8 2.2 -0.8 5.8 0.1 0.1 3.3 3.9 2.2 2.9

1Q 2015F 3.1 2.1 1.0 5.7 0.1 0.2 3.3 4.2 2.4 3.2

2Q 2015F 3.2 2.0 1.9 5.6 0.3 0.5 3.3 4.4 2.6 3.5

3Q 2015F 3.2 2.1 2.5 5.6 0.5 0.9 3.5 4.8 3.0 3.9

4Q 2015F 3.0 2.1 2.8 5.5 0.8 1.1 3.8 5.2 3.5 4.4

1Q 2016F 3.0 2.1 3.0 5.5 1.1 1.4 4.1 5.5 3.9 4.9

2Q 2016F 3.0 2.1 3.1 5.5 1.5 1.8 4.5 5.7 4.1 5.2

2011 1.6 1.2 3.1 8.9 0.1 0.1 3.3 4.7 2.8 3.9

2012 2.3 1.7 2.1 8.1 0.1 0.1 3.3 3.7 1.8 2.9

2013 2.2 1.7 1.5 7.4 0.1 0.1 3.3 4.3 2.5 3.4

2014F 2.5 2.0 1.2 6.2 0.1 0.1 3.3 4.2 2.5 3.3

2015F 3.1 2.1 2.0 5.6 0.4 0.7 3.5 4.7 2.9 3.8

2016F 3.0 2.1 3.2 5.5 1.6 1.9 4.5 5.7 4.2 5.3

Consumption+

Investment

+Government Expenditures

+Exports

GDP = Imports




A number of factors have been cited ascontributing to the slowdown in thelevel of real consumption expendi-tures: recession, declining householdincomes, increasingly unequal wealthdistribution,13 unemployment, and

decreased family formation.

However, a number of the economicnegatives have turned around:

n Improved consumer confidence.

n Additional job creation.

n Recovery in the level of householdassetsboth in terms of the valueof homes and the stock market.

n Reduced levels of consumer debt.Accord ingly, NARs outlook for con-sumption expendit uresa major GDPdriverappears to be positive in 2015.

GROSS PRIVATE DOMESTICINVESTMENT

Gross private domestic investment14is approximately 17 percent of GDP.Residential housing investment com-prises 4 percent of GDP, with non-res-idential and inventory investment atapproximately 13 percent.

Residential Investment

Housing starts declined from 2.2 mil-lion in 2005 to under 500,000 in 2009,per the BEA.15As indicated in Exhibit2-11, a reasonable average expecta-tion for housing starts is approxi-mately 1.5 million units per year. Cur-

rently, housing starts have reboundedto approximately 1 million units peryear, wit h a significant ly larger num-ber of multi-family units than usual.

ight credit conditions and the lin-gering effects of the Great Recessionappear to have negatively impacted

home builders, particularly smalbuilders, who have traditionally pro-duced approximately half the supply

4,000

6,000

8,000

10,000

12,000

14,000

3Q2

014

3Q2

012

3Q2

010

3Q2

008

3Q2

006

3Q2

004

3Q2

002

3Q2

000

$

Billions

Consumption, Previous Rate

Consumption, Actual

Exhibit 2-10. Personal Consumption Expenditures


http://www.federalreser ve.gov/pubs/bullet in/2014/pdf/scf14.pdf. Survey of Consumer Finances for 2013; Over the 2010-2013 time period, the median valu

of real family income fell 5 percent, while mean income increased 4 percent.

U.S. Department of Commerce, BEA, Haver Analytics; dat a current through 3q 2014.

U.S. Department of Commerce. Bureau of the Census. New Residential Construction.

0.0

0.5

1.0

1.5

2.0

2.5

2016

Est

2015

Est

2014

Est

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Millions

Housing Starts

Normal

Exhibit 2-11. Historical Housing Starts

Sources: BEA, NAR, 3q 2014.




of new construction. Te NAR housingstart s outlook for 2014 is 994 thousandunits, 1.2 mil lion units in 2015, and 1.4million units in 2016.

Te decline of housing starts during

the Great Recession created a hous-ing deficit relative to the supply thatwould have been built absent theGreat Recession and its lingeringafter-effects. From 2000 to 2014, netadditions to the housing stock appearto have been deficient by 4.7 millionunits, based on BEA data. Over thesame time period, the economy addedan additional 13 million households.In view of a potential housing short-age, any risks to the housing forecastappear to be on the upside.

InvestmentBusiness Investment,

Private Non Residential FixedInvestment

Business investment, including inven-tory changes, typically accounts for13 percent to 15 percent of GDP. Tisamount declined significantly duringthe Great Recession. Te impact on theeconomy from non-residential fixedinvestment is now substantially abovethe levels experienced a few years ago,as shown in Exhibit 2-12, with the

NAR investment outlook supportingcontinued economic expansion.

GOVERNMENT EXPENDITURES16

With an increased focus on efficienc yand constrained by revenues, govern-ment expenditures as measured inthe GDP declined during the Great

Recession, according to the BEA andas reflected in Exhibit 2-13. Terehas been a recent modest increasein expenditures since then. Futuredecreases in government expendi-tures appear unlikely, so there doesnot appear to be a significant risk tothe economic forecast from decreasedgovernment expenditures adverselyimpacting the GDP.


0

200

400

600

800

1,000

1,200

2Q20

14

2Q20

12

2Q20

10

2Q20

08

2Q20

06

2Q20

04

2Q20

02

2Q20

00

$

Billions

Exhibit 2-12. Business (Non-Residential) Investment





NET EXPORTS17

Net exports are the net balance of totalexports compared to total imports.Te impact on the GDP is the net ofexports (approximately $2.3 trillion)

and imports (approximately $2.9 tril-lion). ypical ly, there is a trade deficit,recently running in t he neighborhoodof $500 billion yearly, according to theBEA. A trade deficit has a negative ordownward impact on the economy.

Te outlook for the trade deficit in thenext year will depend largely on thestrength of the economies of the U.S.trading partners. Foreign recessionscan impact the U.S. economy throughdecreased U.S. exports. Te global eco-

nomic environment remains mixed,as noted by Moodys Analytics:18

n Worldwide, the global economy is

expected to experience global GDPaccelerating to above 3 percent in2015 and 2016.

n Te U.S. and Canada are tran-sitioning to a faster pace of eco-nomic growth than previouslyexperienced.

n GDP in Asia is expected to expandby 4.5 percent.

n Europes economies are soft, andsome economies have recentlyfallen into recession.

n Emerging economies appear to bein a growt h mode.

n South American economies havebeen expanding well below their

potential, as weaker global com-modity prices and high inter-est rates have pushed Brazil,Argent ina, and Venezuela intorecessions.


Ruth Stroppiana, Global Outlook: Economic Prospects Improve, Moodys Analytics, Dismal Scientist.

0

500

1,000

1,500

2,000

3Q201

4

3Q200

9

3Q200

4

3Q199

9

3Q199

4

3Q198

9

3Q198

4

3Q197

9

3Q197

4

3Q196

9

3Q196

4

$

Billions

State and Local

Federal

Exhibit 2-13. Government Expenditures Declined During Great Recession

Source: BEA, 3q 2014.




n China is expected to remain a pri-mary driving force in the globaleconomy, with an economy grow-ing in the neighborhood of 7.5percent.

Geopolitical instability, includingoil production and pricing, has beencited as a risk to global growth (prob-ably the greatest risk in the opinion ofmany experts).19In a McKinsey survey,82 percent of senior executives polledworldwide saw geopolit ical instabilit yas a potential risk to global economicgrowth over the next 12 months.20Tecurrent NAR forecast assumes a con-tinuation of foreign economic trendswit h no spectacular changes in theinternational economic environment.

Given a continuing expansion ofthe U.S. economy, increasing levelsof imports appear likely, along withsome decrease in exports to econo-mies in slower growth modese.g.,South America and Europe. Tere-fore, there could be a modest worsen-ing of the trade deficit with a negativeimpact on the GDP. Te total trade

deficit is currently in the neighbor-hood of $400 billion, as shown inExhibit 2-14; a 20-percent increase inthe deficit would be $100 billion. Put-ting this into perspective, $100 billionis approximately 0.6 percent of a $17

trillion economya percentage gen-erally regarded as relatively minimalChanges in net exports and importsappear unlikely to have a majorimpact on GDP at this time.

0

500

1,000

1,500

2,000

2,500

3,000

3Q20

14

3Q20

09

3Q20

04

3Q19

99

3Q19

94

3Q19

89

3Q19

84

3Q19

79

3Q19

74

3Q19

69

3Q19

64

$

Billions

Imports

Exports

Exhibit 2-14. Net Exports Were About $430 Billion Recently


Elliot Eisenberg gives an example of the intersection of international politics and economics. Oil prices are important economic drivers. Increased oil supply

coupled with slightly declining oil demand due to weakening global growth, led to falling oil prices during 2014. Normally, as the lead oligopolist, Saudi Arabia

would cut production. Tey did not, and Eisenberg speculated th at Saudi Arabia was squeezing other countries for political reasons (e.g., Iran, Iraq and Russia)

which are all heavily-dependent on oil revenues. Elliot F. Eisenberg, Ph.D., GraphsandLaughs, LLC.

Economic Conditions Snapshot, S eptember 2014, McKinsey Global Survey, September 2014. Te other top four risks were increased economic volatility (35

percent), low consumer demand (22 percent), new asset bubbles (20 percent), and sovereign-debt defaults (20 percent).




THE ECONOMIC OUTLOOKUNCERTAINTIES ANDFORECASTING

A variety of assumptions in the mod-eling effort, coupled with a variety of

risks exogenous to the estimation pro-cess, can impact a forecasti.e., cre-ate forecast risk that may cause theeconomic projections to be inaccu-rateeither upwards or downwards.

n Assumptions about the underly-ing economic relationships driv-

ing the economy: Differences inmodeling assumptions may resultin differences in conclusions. Forexample, the choice of poten-tial economic driverse.g., GDP,

household wealth, prices of vari-ous assets, etc.can impact theestimation of economic relation-ships. Assumptions concerningconsumer and business behavior,uncertainties, and the character-istics of economic change impactthe modeling effort. Te possibil-ity of unknown unknowns entersthe forecasting procedure at this

point. For example, the extent andimpact of adversities in real estatemarkets and their impact on theoverall economy during the GreatRecession could have been termedone of the unknown unknowns

prior to the Great Recession.

n Assumptions about exogenous

variables: Assumptions aboutexogenous eventse.g., changesin Federal Reserve policies,government expenditures, theimpacts of foreign affairs on eco-nomic activity, changes in govern-ment regulations, etc.can alter aforecast. Tese are the unknownunknowns: economists typicallyhave minimal, if any, expertise in

predicting the occurrence of thesetypes of events. However, theseare also the types of events thatcan strongly impact an economicoutlook.

Te familiar statement On the onehand, but on the other handfrequently associated with eco-nomic commentaries highlights that

unknown unknowns and uncertain-ties in exogenous events can changethe forecast. Terefore, any economicforecast is based on an understand-ing of the economy and a variety ofassumptions which may or may not

be accurate. Te forecasting effort canproduce a number of scenarios basedon differing behaviora l and exogenouassumptions. A major value from theforecasting scenario, as provided inChapter 5 of this report, is the exami-nation of the impacts of uncertaintieson economic outcomes.

Te Uncertainties

A variety of uncer tainties are associated with t he current forecast:

Foreign Economic rends/Impacts

Approaching 2015, we find that someforeign economies are expanding andsome are not. Disturbances whichdecrease international trade w ill havea negative impact on the U.S. econ-omy. Foreign economic slowdownsare a downside risk to the forecast.

Monetary Policya significant risk

Trough quantitative easing, the Fed-eral Reserve has kept interest ratesartificially low, with the objectivebeing to stimulate the economy andachieve a lower unemployment rateInterest rates impact t he economy. Teend of quantitative easing is likely tolead to higher interest rates, a down-side risk to the forecast. Te size of therisk should be relatively minimal forthe next year, given that interest rateincreases are likely to be orderly.

Credit Availabilitya significant

risk: Low interest rates are irrelevantif credit is not available to responsiblequalified borrowers. Many financiainstitutions have been reported ashaving balance sheet problems, e.gloan portfolios that are excessivelyrisky and have a lack of capital relativeto potential risks and liabilities. As aresult, it appears that overall creditavailability has become excessively




tight. For example, NAR has estimatedthat home sales could rise by 10 per-cent if normal credit requirementsfor home purchasers were in place. Aloosening of credit, based on recentcomments by senior government offi-

cials, should have a positive effect onthe forecast. According to a GoldmanSachs study, credit availability is moreimportant than cyclical factors ofunemployment and income in deter-mining home sales. According to esti-mates in the study, the lack of creditavailability contributed to about halfof the housing market weakness in thepast year.21

Te Federal Housing Finance Agency,the agency that regulates the govern-

ment-sponsored enterprises (GSEs)Fannie Mae and Freddie Mac, has ini-tiated several measures to increasecredit availability for responsible bor-rowers. For example, the acceptanceof loans originated with a 3-percentdown payment under certain qualifi-cation guidelines by the GSEs shouldincrease credit availability to first-time buyers significantly. In the caseof Freddie Mac, borrowers will berequired to participate in a borrowereducation program. In the case ofFannie Mae, borrowers will still haveto meet the standard eligibility under-writing requi rements relat ing toincome, employment, and debt, andwill be required to purchase privatemortgage insurance.22

Housing and Construction Uncer-tainties: Following the Great Reces-sion, housing starts have been belowthe normal level of 1.5 million unitsper year. Credit availability and

increased risk aversion appear to havehad a major impact on new construc-

tion. Assuming an easing of credit,this is an upside risk to the forecast.

College Student Debt: Student debtis currently in excess of $1 trillion,according to the Federal Reserve Bank

of New York:23

n Outstanding student loan bal-ances reported on credit reportsincreased to $1.13 trillion as ofSeptember 30, 2014, representingan increase of about $100 billionfrom 1 year ago.

n About 11.1 percent of aggregatestudent loan debt was 90+ daysdelinquent or in default.

Te average amount owed per bor-rower grew at 7 percent a year between2004 and 2012,24 and some studentdebt levels may be negatively impact-ing home ownership.25 Te media

have been filled with stories of collegegraduates working at near-minimumwage levels while owing tens of thou-sands of dollars. Such individuals areallegedly consigned to almost perma-nent indigence. However, it is impor-

tant to note that student debt comes inall sizes: 12.7 percent of debtors owemore than $50,000 according to Stu-dent Debt Overview, but 40 percentof debtors owe less than $10,000. Student debt levels do not appear likelyto impact the economic projectionsin 2015, but for the longer term, a sig-nificant number of former studentsowe significant amounts of money to amuch higher degree than has been thecase historically.

Household Formation: Householdformation, as charted in Exhibit 2-15is an important economic driver, gen-erally creating a need for space, homefurnishings, etc. o the degree that

Hui Shan, Scotsman Guide, July 28, 2014.22 http://www.fhfa.gov/Media/PublicAffairs/Pages/Statement-of-FHFA-Director-Melvin-L-Watt-on-Release-of-Guidelines-for-Purchase-of-Low-Down-

Payment-Mortgages.aspx.

Quarterly Report on Household Debt and Credit, November 2014, Federal Reserve Bank of New York.

Student Debt Overview, Postsecondary National Policy Institute (PNPI) 8/14/13, Meta Brown, Federal Reserve Bank of New York.

Meta Brown, Sydnee Caldwell, Young Student Bor rowers Retreat f rom Housing and Auto Markets, April 17, 2013, Liberty Street Economics.

-500

0

500

1,000

1,500

2,000

2,500

3,000

Jun

201

4

Jun

201

2

Jun

201

0

Jun

200

8

Jun

200

6

Jun

200

4

Jun

200

2

Jun

200

0

Jun

199

8

Jun

199

6

Jun

199

4

Jun

199

2

Jun

199

0

Households

Exhibit 2-15. Households Added (Historical Formation)

Sources: U.S. Census Bureau, Haver Analytic s, October 2014.




this trend changes in the next sev-eral years, the change is likely to beupwards, given the maturation of theGeneration Y demographic group.

Income and Wealth Distribution:

Economic data indicate an increasingconcentration in income and wealthcompared to a decade ago. Te Fed-eral Reserves Survey of ConsumerFinances for 2013 has reported thatover the 2010-2013 time period, themedian value of real family income fellby 5 percent, while the mean incomeincreased by 4 percent.26 Decreasedpurchasing power, coupled with lim-ited income expectations by the bot-tom 60 percent of the population, maybe holding the economy to a lower

expansion path.

Job Availability and Growth: Unem-ployed, underemployed, and missing-from-the-labor-force workers havecontinued to be a problem during therecent economic expansion. Unem-ployment levels have been high rela-tive to previous experience and in

comparison to the 5-percent rate fre-quently regarded as desirable. How-ever, the job markets are easing, withmore people finding work. If this trendaccelerates, there would be additionalupscale potential to the forecast.

Al l of the uncer tainties mentionedexcept for the likelihood of increasedcredit availabilityare somewhatunpredictable. Te current NAR fore-cast is based on the extrapolation ofcurrent trends in the risk factors. Teone major uncertaintycredit avail-abilitynow seems to be much lessuncertain based on comments bysenior government officials; accord-ingly, the risk to the forecast is onthe upside, and this forecast may be

somewhat conservative.

Forecasting Conclusions

As 2015 continues, NAR expects ameasured expansion (stronger thanthe past few years) of the economy.A number of negative factors hold-ing the economy back have been

mentioned. Tese factors are important in terms of their negative impactson the economy. For example, the Millennial Generation is larger than theBaby Boom Generation, which shouldauger well for economic growt h. How

ever, Millennials have been chal-lenged by student loans, a difficultjob market in terms of job availabi lity and income, a slow economy, andtight monetary policies. Some of theseproblems are changing (e.g., crediavailabi lity, state of the economy), buthe economy is unlikely to move for-ward at a max imum rate until issuesof job markets, family formation, andhousehold balance sheets are significantly improved for the Millenniademographic.

As economic problems are resolvedone would expect to see the economymove forward somewhat more rapidlythan is currently the case. At this timeNARs outlook is for moderate eco-nomic growth in 2015.

http://www.federalreserve.gov/pubs/bulletin/2014/pdf/scf14.pdf.




3 THE CAPITAL MARKETCAPITAL WATERS RUN DEEP




CAPITAL WATERS RUN DEEP

As 2015 gets underway, the invest-

ment world is flush with capital andthe U.S. is generally regarded as a topdestination for much of this invest-ment capital. Te U.S. stock markethas recorded new all-time highs, withthe Dow Jones Industrial Average(DJIA) topping 18,000 and the S&P500 topping 2,000 as of late Decem-ber 2014. U.S. reasury yield rateshave been declining due to increaseddemand, as have government bondrates in many other countries. As atangible, transparent, and relatively

safe investment in uncertain times,commercial real estate, especiallyin the U.S., also continues to attractmuch capital (both foreign anddomestic).

In fact, according to results from the23rd annual survey conducted bythe Association of Foreign Investorsin Real Estate (AFIRE), the U.S. wasvoted the most stable and secu recountry for investment, outstrippingsecond-place Germany by 55 percent-age points and third-place UK by 60percentage points.27 Te AFIRE sur-vey results also ind icated that theU.S. offers the best opportunity forcapital appreciation, out-performingsecond-place Spain by 34 percent-age points and third-place UK by 40percentage points. In addition, NewYork City reclaimed first place as theNumber 1 global city for commercialreal estate investment, per AFIRE.

Tese investment attitudes for com-mercial real estate are reflected inExhibit 3-1, which compares thegrowth of total commercial propertytransactions to cross-border acqui-sitions by indexing the percentagechange in dollar acquisition volume

on a 12-month trailing basis. As

shown, by the end of third quarter2014, cross-border capital investmenthad reached levels seen in mid-2007,whereas tota l acquisition volume wascloser to mid-2006 levels.

In fact, commercial real estate invest-ment in general is more closelyresembling capital investment inthe pre-credit crisis years leading upto the Great Recession. Accordingto Situs RERCs historical analysis,the gap between the availability (or

amount) and discipline (or under-writi ng standards) of capital is wid-ening (see Exhibit 3-2) similar to 2007levels, as capital floods the marketand underwriting standards loosen.Tis is starting to raise alarm bells,and given the expected further loos-ening of underwriting standards andcontinued capital inflows, the gap

between availability and discipline

wi ll l ikely continue to widen t hrough-out 2015, especially if interest ratesremain low and the U.S. remains asafe haven for investment. (Tis graphhas historically provided a good indi-cator when market prices were outpacing values, as capital was pushingprices, versus prices being led by thefundamentals.) Compared with thepre-credit crisis period, we note thatthe market is not at the point of dis-parity where capital availability out-paced discipline by a relatively large

margin. However, the market is at aninflection point and if investors compare to historical time frames, theremay be 1 to 2 years before the nexdown cycle. (Yes, there will almostcertainly be another down cyclethequestions are when, why, and howsevere.)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

3Q201

4

3Q2013

3Q2012

3Q2011

3Q2010

3Q200

9

3Q200

8

3Q200

7

3Q200

6

3Q200

5

3Q200

4

3Q200

3

3Q200

2

Index

Cross-Border Capital AcquisitionsTotal Acquisitions

Exhibit 3-1. Cross-Border Percentage Change in Acquisition Volume

NOTE: Index reflects percentage change in dollar acquisition volume on a 12-month trailing basis.Sources: Real Capital Analy tics, indexed by Situs RERC, 3q 2014.

23rd annual survey conducted by the Association of Foreign Investors in Real Estate (AFIRE) in fourth quarter 2014 by the James A. Graaskamp Center for Rea

Estate, Wisconsin School of Business, and issued on Jan. 5, 2015.




KEY CAPITAL CONCERNS FOR 2015

When Will Interest Rates Go Up?

Although the federal funds rate (short-term interest rate) has remained at 0

percent to 1/4 percent for much lon-ger than most investors would haveguessed, the main concerns noware the timing for when short-termand long-term interest rates begin toincrease, and how will the two ratesmove: in tandem, lead, or lag oneanother?

Many forecasters believe that the Fed-eral Reserve will start to raise short-term interest rates in mid-2015. How-ever, according to the Federal Open

Market Committees (FOMCs) end-of-the-year policy statement releasedDecember 17, 2014, the Commit-tee judges that it can be patient inbeginning to normalize the stance ofmonetary policy, and other forecast-ers believe the raising of short-termrates could be several years away yetbecause of slowing economies in therest of the world. Further, the FOMCreiterated that it likely will be appro-priate to maintain the 0 to percenttarget range for the federal funds ratefor a considerable timeespecially ifprojected inflation continues to runbelow the Committees 2-percent lon-ger-run goal, and provided that longer-term inflation expectations remainwell-anchored.

One of the clearest indications of thedirection of interest rates is the direc-tion of government bonds. Commer-cial real estate, as well as nearly allother investments in the U.S. and in

most developed countries, uses the10-year reasury yield rate as a risk-free rate to compare investment yields.For the past 7 years, many investorshave been hedging for the 10-yearreasury yield rate to jump back up towhat is typically considered the his-torical norm. But as Exhibit 3-3 shows,risk-free rates have been consistentlydeclining for a couple decades, and the

direction of change has not played outas many investors have been expect-ing. In addition to investors updat-ing their definition and expectationsfor interest rates and their impact oninvestment alternations, Exhibit 3-3shows that the downward trend could

last longer than predicted, and manymarket participants are downgradingtheir expectations on risk-free ratesand the timing of the adjustment. Inearly 2014, most investors expected10-year U.S. reasurys to be 3 percentplus by now, and they based projected

1

2

3

4

5

6

7

8

9

10

Discipline

Availability

3Q2014

3Q2013

3Q2012

3Q2011

3Q2010

3Q2009

3Q2008

3Q2007

3Q2006

3Q2005

Rating

Exhibit 3-2. Historical Availability & Discipline (Underwriting Standards) of Capital

Source: Situs RERC Institutional Investment Survey, 3q 2014.

0

2

4

6

8

10

12

14

16

18

Jul-1

4

Jul-1

0

Jul-0

6

Jul-0

2

Jul-9

8

Jul-9

4

Jul-9

0

Jul-8

6

Jul-8

2

Percent

10-Year UK Gilt Yield

10-Year US Treasury Yield

10-Year German Bund Yield

Exhibit 3-3. 10-year Government Bond Yield Rates (Historical Treasury, Bund, Gilt Yields)

Sources: Federal Reserve, OECD, 3q2014.




relative investment performance onthis forecast. en-year U.S. reasuryswere about 2 percent at the time of thiswrit ing, and most investors do not seea significant change over the near termas the weight of capital and the search

for safety puts strong downward pres-sure on U.S. reasurys, which arehigher than government bond yieldrates in other countries like Germanyand Japan.

Credit Markets Healthy, or Dj VuAll Over Again?

More and more, the debt market isstarting to resemble 2005 and 2006,particularly as it relates to the sizeand quality of originations. Accord-

ing to Commercial Mortgage Alert,the issuance of CMBS in the U.S. in2014 ($94.1 billion) reached aboutthe same level as in 2004 ($95.6 bil-lion), as shown in Exhibit 3-4, andmany investors expect that this issu-ance will accelerate similarly to thatin 2005 through 2007, especially ifunderwriting standards continue toloosen.

Meanwhile, the market continues todeal with the wave of commercial realestate maturing over the next sev-eral years. Although the outlook forthese maturing loans has improvedgreatly since 2009, as many have beenresolved or restructured, there remains

well-placed concern over other maturing CMBS loans which are considered zombie loans because they areunable to be refinanced. In additionaccording to Morningstar Credit Rat-ings, LLC, from November 2014 untiNovember 2015, 5.19 percent of loanswere already delinquent compared tothe total CMBS delinquency rate of 4.15percent in October 2014.

Will the next wave of CMBS maturities be as challenging as t hose in 2007?According to Morgan Stanley Researchand repp, the weighted-average loanto-value (LV) ratio as of third quarter2014 was 66 percent, which was signifi-cantly looser than in third quarter 2010(approximately 53 percent). Howeverthe current LV ratio is still tighterthan the underwriting standards priorto the LV peak of 71 percent in second

quarter 2007.

Additiona lly, in third quarter 2014the Moodys LV ratio had one of thelargest quarter-to-quarter increases inCMBS loans. Te LV increased from108.3 percent to 112.2 percent, and signaled that leverage in the market willikely handily surpass the pre-crisispeak of 118 percent before third quarter

0

50

100

150

200

250

201

4

201

3

201

2

201

1

201

0

200

9

200

8

200

7

200

6

200

5

200

4

200

3

200

2

200

1

200

0

$

Billions

Exhibit 3-4. CMBS Issuance in U.S. (2000 through 2014)

Source: Commercial Mortgage Alert, Jan. 5, 2015.




2017. On top of that, the distribution ofthe Moodys LV ratio has shifted andlooks eerily similar to that of 2007 butwithout as much risk.

Meanwhile, Morgan Stanley reported

that in third quarter 2014, the weighted-average debt yield broke below the10-percent mark for the first time everto 9.6 percent, as shown in Exhibit 3-5.However, this is somewhat deceiving,given the difference in the 10-year U.S.reasury rate then compared to now.

Te similarities in CMBS loans todaycompared to those leading up to the2006-2007 credit crisis are occurringamidst a significantly altered back-drop, and thus will likely lead to differ-

ent results. Very much absent from thecurrent CMBS outlook is an aggressivemarket for collateralized debt obliga-tions (CDOs). In the few years prior tothe Great Recession, the CDO marketbecame substantially and systemicallymore risky when it became a majorfinancing mechanism for the mostjunior CMBS bonds and more notori-ous subprime residential mortgagebacked securities. According to Com-mercial Mortgage Alert, real estate CDOissuance peaked in 2006 at nearly $40billion, but through the first 9 monthsof 2014, totaled only $3.4 billion.

Tere are other reasons why we donot generally anticipate a repeat ofthe credit crisis of 2006 and 2007, andkey among them is improved regula-tions. Since then, the rating agencieshave been required to become morethorough and critical in their analysis.Tere was also the passing of the DoddFrank Wall Street Reform and Con-

sumer Protection Act, as well as BaselIII28. Tese improvements increasedthe minimum capital requirements,and take into account risk-weightedassets for large bank holding compa-nies. In addition, requirements havebeen set up to mitigate risks via mini-mum liquidity ratios and leverage

ratios, as well as capital conservationand counter-cyclical buffers. Fur-thermore, the largest banks must gothrough the Comprehensive Capi-tal Analysis and Review (CCAR) toassess if they will have sufficient capi-tal to withstand normal, adverse, andseverely-adverse economic scenarios.

Te Dodd Frank Wall Street Reformand Consumer Protection Act also spe-cifically addressed the CMBS market.Recently finalized risk-retention rulesrequire that CMBS sponsors retain aminimum of 5 percent of the risks ona transaction, which can be purchasedby up to two different third parties on apari passu basis. Tere is additionaltransparency through required finan-cial disclosures, as well as an operatingadvisor, who has no conflicts of inter-est and reports with impunity to the

investors.

Risk From Across the Pond

As 2015 gets underway, economicgrowth throughout Europe remainssluggish and there are deep con-cerns that the European Unions

(EUs) deflationary environment maypush the EU economy into recessionAccording to most estimates, including those made by the Organizationfor Economic Cooperation and Devel-opment (OECD) and the InternationaMonetary Fund (IMF), investors shouldexpect the EU economy to continue itslethargy for the near term.

Te labor situation in Europe bouncedbetween stagnation and mild improvement in third quarter 2014. According toEurostat, the EUs seasonally-adjustedunemployment rate decreased to 10.0percent in October 2014, while unem-ployment in the euro zone remained11.5 percent in October.

In addition, geopolitical uncertaintyhas increased across the globe, andthe conflict in Ukraine, which has

already damaged business relationsbetween Russia and its neighborsseems nowhere near resolution. Addto that terrorism in the Middle Eastthe economic challenges posed bylow oil prices, and the political fracturing in the EU as the ECB begins toinitiate quantitative easing, and it is

4

6

8

10

12

14

16

3Q20

14

1Q20

14

3Q20

13

1Q20

13

3Q20

12

1Q20

12

3Q20

11

1Q20

11

3Q20

10

2Q20

08

4Q20

07

2Q20

07

4Q20

06

2Q20

06

4Q20

05

2Q20

05

Percent

Exhibit 3-5. CMBS Weighted-Average Debt Yield

Source: Morgan Stanley Research, 3q 2014.

Tird document issued by the Basel Committee on Banking Supervision.




increasingly likely that many investorswil l continue to be attracted to safe,tangible, and transparent investmentssuch as commercial real estate in 2015.

CAPITAL ORIGINATION

According to Situs RERCs analysis,an estimated $5.06 trillion is currentlyinvested in commercial real estatein the U.S. Of this total, $3.29 trillionis debt-driven, and $1.77 trillion isequity-driven. Key investors in the debtmarket include U.S. chartered deposi-tory institutions (banks and savingsinstitutions); GSEs; CMBS, CDOs, andother asset-backed securities (ABS);life insurance companies; other debt,

including real estate investment trusts(REIs); and foreign banking offices.Equity investors include private inves-tors; REIs, pension funds, foreigninvestors, life insurance companies,commercial banks, corporations,GSEs, and others.

Commercial Real Estate Debt Market

According to the Federal Reserve, thetotal outstanding debt for commer-cial and multifamily mortgages from

second quarter 2013 to second quar-ter 2014 increased by 4.4 percent toapproximately $3.29 trillion (see totalcomposition in Exhibit 3-6). Among themain lender types, debt in U.S. char-tered depository institutions increasedfrom 47 percent to 48 percent of com-mercial real estate loans in secondquarter 2014. In addition, the total loan

holdings for REIs increased by 16.6percent to $194 billion, which camealmost entirely during fourth quarter2013, per the Federal Reserve. Givencurrent market conditions and trendsgrowth near this level can be expectedagain during the next couple yearsalthough it is unlikely to overtake as amajority lender.

Commercial Real Estate Equity

Market

Situs RERC estimates that, based on itsevaluation of various sources, equityinvestments in commercial real estatetotal $1.77 trillion (see compositionin Exhibit 3-7). Private investors holdthe largest amount of commercial reaestate equity with 43.72 percent of thetotal equity investment. Te second

largest equity group consists of REIswith 34.40 percent of t he total. Pensionfunds contribute 14.54 percent of thetotal.

According to Situs RERCs analysis, debt originations increased fornon-bank financial companies andfor regional banks, but declinedfor national banks and insurance

U.S. Chartered DepositoryInstitutions

48%

CMBS, CDO andother ABS

13%

Life InsuranceCompanies

11%

Foreign Banking Officesin U.S.

1%

GSEs

18% Other10%

Fixed Income Markets - $3.29 Trillion

Lender Composition

Exhibit 3-6. Commercial Real Estate Debt Universe

Source: Federal Reser ve Flow of Funds, 2q 2014.




companies in first half 2014. Equityinvestment increased among privateinvestors, REIs, institutional andequity funds, and cross-border inves-tors (see highlights in Exhibit 3-8 onPage 34).

Equity to Debt

Increasingly, trusts and funds whichhad been aligned with equity areslowly starting to integrate debt as anessential part of their risk diversifica-tion and investment model.

For example, in December 2012, Black-stone acquired C Investment Man-agement Co. LLC for $21.4 million andbecame Blackstone Mortgage rust.

According to their financial reports,Blackstone Mortgage rust had a204-percent growth in loan origina-tions to end third quarter 2014 with$3.9 billion in originations, comparedto $1.3 billion in third quarter 2013.Te 55 different loans which make upthe portfolio have a weighted-averageLV of only 64 percent, and are mostheavily invested in New York, Califor-nia, and the UK. Notably, all of theseloans were originated based on a float-ing rate against the London InterbankOffered Rate (LIBOR), and as such, arepositioned to deal with increases inbank lending. (All else being equal, a100-basis point increase in the LIBORwould increase net interest income by$15 million per year, or $0.26 per share,as reported in Blackstone Mortgagerusts public financial reports.29)

For this same reason, many REIs arealso diversifying more into debt instru-ments as they focus on risk versus return

and chasing market opportunities. Itshould be noted that offerings from alltypes of REIs have increased signifi-cantly over the past few years. Accordingto data from the National Association ofReal Estate Investment rusts (NAREI),equity capital raised by REIs peaked in2012 (see Exhibit 3-9), while offerings of

Private Equity43.72%

REITs34.40%

Pension Funds14.54%

Equity Investor Composition - $1.77 Trillion

Life Insurance Cos.2.08%

Commercial Banks1.28%

Corporations0.96%

Foreign Investors

2.47%

Govt, GSE & Others0.55%

Exhibit 3-7. Commercial Real Estate Equity Universe

Source: Situs RERC Estimate (based on NAREIT, PREA, AFIRE, Preqin, RCA, and NCREIF), 4q 2014.

Tis includes the impact of LIBOR floors for loan receivable investments, per the Blackstone Mortgage rust Report for Tird Quarter 2014 Results, Oct. 28, 2014.




debt securities for REIs have contin-ued to increase and have already sur-passed last years value with $30.9 bil-lion as of November 2014.

CAPITAL TO FURTHERDRIVE MARKET IN 2015

he lavish amount of capital that hasbeen directed toward commercialreal estate and other investments in2014 shows no sign of abating in 2015.In fact, respondents to Situs RERCsquarterly institutional investmentsurveys have noted throughout mostof the year that capital placementdefies logic and that there seemsto be no end in sight to the amount of

capital investors are willing to payfor a quality property. he abun-dance of capital has helped to driveprices higher, and as we look to 2015,we recognize that we are at an inflec-tion point where the availability ofcapital may be outpacing discipline(underwriting standards), and assuch, property prices may also beoutpacing property va lues.

A broader discussion of proper ty fu n-damentals is presented in Chapter 4of this report, a nd our overall outlookfor 2015 is included in Chapter 5, buta summary of our expectations30 forthe capital markets as they relate toinvesting in commercial real estatefor the year ahead is listed below:

n It is likely that huge amounts ofcapital will be invested in com-mercial real estate again in 2015.Both debt and equity investmentwi ll likely inc rease, and whi le

investors will likely generallyrepeat the investment patterns setin 2006 (where availability pres-sured underwriting standards),new banking regulations andother investment requirements

are expected to prevent anothercredit crisis from occurring.

n As the amou nt of capital is plac-ing downward pressure onunderwriting s

Documents

Expectations and Market Realities in Real Estate in 2015 02-06-2015