TOPIC 10

1. TOPIC10 Real Estate Market Analysis: Chicago (Plus my overall market forecasts)

2. Real Estate Market Analysis: Why do it? • “Real estate market analysis” refers to analyzing a variety of real estate decisions. • Where to locate a branch office? • What size or type of building to develop on a specific site? • What type of tenants to look for in marketing a particular building? • What the rent and expiration term should be on a given lease? • When to begin construction on a development project? • How many units to build this year? • Which cities and property types to invest in so as to allocate capital where rents are more likely to grow? • Where to locate new retail outlets and/or which stores should be closed?

3. Broadly Speaking… • Real estate market analysis usually requires quantitative or qualitative understanding (& prediction) of both the demand side and supply side of the space usage market relevant to some real estate decision. • The focus might be micro-level, such as a feasibility analysis for a specific site or property • Or, the focus might be more general, such as a general characterization of the supply/demand conditions in a particular space submarket.

4. Variables of Interest in Market Analysis • To evaluate a real estate space submarket, analysts tend to focus on a few primary indicators that characterize both the supply and demand sides of the submarket and the balance (equilibrium) between them. • Vacancy rate • Market Rent • Quantity of new construction starts • Quantity of new construction completions • Absorption of new space

5. Vacancy Rate • By definition, the vacancy rate refers to the percentage of the stock of space in the market that is not currently occupied. • Vacancy Rate = Vacant Space/Total Space • The vacancy rate reflects the balance between supply and demand. • In most markets, it is normal for some vacancy to exist (the natural vacancy rate) even when supply and demand are in balance. • When actual vacancy rises above the natural vacancy rate, rents tend to fall. • When actual vacancy falls below the natural vacancy rate, rents tend to increase. • Natural vacancy rate can be 6-12%

6. Market Rent • By definition, market rent is the level of rents being charged on typical new leases currently being signed in the market. • asking rents may differ from effective rents • Market rent is another indicator of the balance between supply and demand in a market. • Can be tricky to measure because • it is private information and • lease terms may differ dramatically from tenant to tenant • Result: Sometimes hard to get accurate “rent measures” – usually collected via surveys.

7. Constructions Starts and Completions • Construction is an important “supply side” indicator. • “Starts” indicate the amount of space currently in the “pipeline” and likely to be added to the supply in the near future • “Completes” indicate the amount of space just arriving in the market. • Of course, we need to consider the net addition to supply (after taking demolition and renovations into account).

8. Absorption of New Space • By definition, absorption refers to the amount of additional space that becomes occupied during a year. • Absorption is a “demand side” indicator (i.e., does not account for amount of supply available). • Gross absorption – total amount of space leased, regardless of where tenants come from • Net absorption – net change in the amount of space occupied in a market. • Positive net absorption rates: Demand increasing in market • Negative net absorption rates: Demand falling in market

9. The Concept of “Months Supply” • The variables we just reviewed are commonly used indicators of supply/demand conditions in space submarkets. • The concept of “months supply” combines several of these variables to help us understand a market even better. • By definition, months supply is the sum of current vacant space in the market and new construction started but not completed, divided by 1/12th of the annual net absorption in the market. • This measure tells how long it will take (in months) for all of the vacant space in the market to be absorbed, driving the vacancy rate to zero. • Analysts compare the months supply to the length of time it takes to complete new construction to see if the market can support a new project. If the months supply is much greater than the average construction period, the market is “oversupplied.” Otherwise, it might be time to start a new project in this market. • Meaningless measure if net absorption is negative

10. Some Tips for Market Analysis • Define the market carefully along geographic and usage dimensions, recognizing that most metropolitan areas form markets that can be usefully divided into smaller submarkets. The next slide describes how the Atlanta office market can be “divided.” • Carefully consider the time period to be covered in the analysis • 5 – 10 years into the future is desirable • 3 years is more feasible in most cases • Recognize the differences between and the benefits of a simple trend extrapolation and a structural analysis • Trend extrapolation predicts the future purely based on historical trends and patterns • Structural analysis attempts to predict the future by identifying and quantifying the underlying determinants of market trends.

11. Performing/Understanding a Market Analysis • In both types of analysis (extrapolation and structural) the steps are: • First, inventory the existing supply and evaluate the pipeline. • Second, relate the demand sources to the space usage demand. • Third, forecast future demand for and supply of space • Compare the forecasted demand for space with the forecasted supply of space to see if the market will be “over” or “under” supplied in the future. • In tight markets (under supplied, landlord market), we expect to see higher rents and lower vacancy rates. • In loose markets (over supplied, tenant market), we expect to see lower rents and higher vacancy rates.

12. Recent “Hot” Office Property Markets

13. Recent “Cool” Office Property Markets

14. U.S. Office Market Vacancies 2002Q1 – 2005Q1 (Average Gross Asking)

15. U.S. Office Market Net Absorptions 2002Q1 – 2005Q1 (Average Gross Asking)

16. Chicago Office Market (Downtown and Suburbs): 2005Q1 (Average Gross Asking) Chicago Office Inventory (2004): 117 million sf Chicago Office Vacancy(2005Q1): 15.7% (highest rate since 1996) Downtown Vacancy (2005Q1) = 18.4% (21.4 million sf of space available for leasing)

17. Chicago Office Market (Downtown and Suburbs): 2005Q1 Net absorption rate for downtown 2005Q1 was -1 million sf.

18. Chicago Office Market (Downtown): 2005Q1 Construction Activity Due to Become Available in 2005-2006: 4 million Sq

19. Asking Net Rent Prices Chicago 2004 • Class A (prime): $18 - $25 per sf • Class A (broad): $9 - $25 per sf • Class B $7 - $15 per sf • Predicted to fall further through 2005 given the high vacancy rates • Concessions will increase (free month rent) • Large amount of activity by tenants to extend leases (look in lower rates while they have the power).

20. Chicago Market Break Down

21. Forecast from the Chicago Office Market (Downtown) Chicago unemployment rate not decline (as of yet) – looking for a recovery?

22. Chicago Forecasts • Imminent Demand • No signs of a dramatic increase in demand on the local level (no industry shift moving towards chicago) • U.S. economy may be “fragile” – oil prices/global economic uncertainty acting on a drag on U.S. economy (see recent trend in stock prices) • Demand predictions “moderate” at best • Supply • Lots of slack in the office market (vacancies high and construction continuing) • Rents will not pick up for awhile (good for tenants). • Still profitable to build (new construction is filling up quickly (at expense of existing properties) – however rents in new construction still low). • I would not develop office space in chicago at this time! Interest rates likely to rise (to fight inflation) – decreases returns to owning (along with low rents and high vacancies).

23. Chicago Office Forecasts • Imminent Demand • No signs of a dramatic increase in demand on the local level (no industry shift moving towards chicago) • U.S. economy may be “fragile” – oil prices/global economic uncertainty acting on a drag on U.S. economy (see recent trend in stock prices) • Demand predictions “moderate” at best • Supply • Lots of slack in the office market (vacancies high and construction continuing) • Rents will not pick up for awhile (good for tenants). • Still profitable to build (new construction is filling up quickly (at expense of existing properties) – however rents in new construction still low). • I would not develop office properties in Chicago at this time! Interest rates likely to rise (to fight inflation) – decreases returns to owning (along with low rents and high vacancies).

24. Chicago Retail Forecasts • Retail development is a better opportunity • Vacancies are lower • Effective rents have been increasing slightly • People still consuming in Chicago (both natives and tourists). Residential areas of Chicago are still developing (south/west loop). • Interest rates will still likely increase – as a result, financing costs will still rise.

25. Other Markets: Downtown Office Boston

26. Other Markets: Downtown Office Boston

27. Other Markets: Downtown Office San Francisco

28. Other Thoughts…. • My macro assessment • Fundamentals “solid” not “strong” • Oil and Inflation (has me worried) • Consumers and Business (going strong) • Government (too much debt) • Net Exports (of no concern to me) • Business investment is most stable! Lots of capacity to expand – they are hesitant given past mistakes (late 1990s) and oil/political uncertainty. • Residential Property Markets • They will come down (either bubble burst or supply adjusts) • Increase in interest rates may quicken this effect • Re-adjustment will occur slowly (it always does) • Will investors adjust to/plan for a higher (normal) interest rate regime?