Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 1 of 12 EXHIBIT 16 Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 2 of 12 Principal Real Estate Investors – Real Estate Research Corporation – CBRE/Torto Wheaton Research Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 3 of 12 Principal Real Estate Investors Principal Real Estate Investors is the dedicated real estate investment management group of Principal Global Investors. It is the fourth largest real estate investment manager in the U.S. with over $40.4 billion in commercial real estate assets under management. With a staff of 475 professionals, Principal Real Estate Investors provides in-depth transaction and research coverage of over 60 markets. This expertise, combined with state-of-the-art investment and portfolio management capabilities, allows The Principal to identify a broad range of investment opportunities and creative strategies for its clients. Principal Real Estate Investors actively invests in all of the real estate quadrants – public, private, fixed income, and equity – and provides timely execution of complex transactions, both large and small, across property types and geographic regions. Real Estate Research Corporation Founded in 1931, Real Estate Research Corporation was one of the first national firms dedicated to commercial real estate research, valuation, and consulting services. Today, RERC is known also for its fund advisory services, independent fiduciary services, management information systems, and litigation support. With its practical know-how and discipline, RERC is well-suited to serve as the adviser to a global real estate fund. RERC also serves as the independent fiduciary and oversees all real estate investment- and valuation-related activity of a 200-property, $17 billion real estate account for a major pension fund. In addition, RERC provides web-based portfolio technology solutions to the trustee of a $6 billion fund comprised of 150 properties. Further, RERC has provided fairness opinions on dozens of major acquisitions totaling over $1 billion. RERC’s valuation services also have proven rewarding to real estate owners and investors for tax appeals and expert witness testimony in partnership disputes. CBRE/Torto Wheaton Research CBRE/Torto Wheaton Research is a full-service research and investment advisory firm specializing in commercial real estate markets throughout the U.S. and Canada. Founded in 1982, its industry-leading research, market expertise, and strategic partnerships provide clients with tactical advice and strategic direction to identify market opportunities, enhance performance, and manage risk. CBRE/ Torto Wheaton Research is internationally recognized for its solid foundation in economics, accurate forecasts, analytical expertise, and providing clients with unparalleled insight into the dynamics of the real estate market that impact performance. Its products and services cover up to six property types and 300 metropolitan markets throughout the U.S. and Canada. Principal Real Estate Investors Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 4 of 12 Principal Real Estate Investors – Real Estate Research Corporation – CBRE/Torto Wheaton Research Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 5 of 12 © 2007. Principal Real Estate Investors, Real Estate Research Corporation, and CBRE/Torto Wheaton Research. All Rights Reserved. No part of this publication may be reproduced in any form electronically, by xerography, microfilm, or otherwise, or incorporated into any database or information retrieval system, without the written permission of the copyright owners. Expectations & Market Realities in Real Estate: 2008 is published by: Principal Real Estate Investors 801 Grand Avenue Des Moines, IA 50392 Real Estate Research Corporation 980 North Michigan Avenue, Suite 1110 Chicago, I L 60611 CBRE/Torto Wheaton Research 200 High Street, 3rd Floor Boston, MA 02110 Disclaimer: This report contains general information only on investment matters; it should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information it contains does not take into account any investor’s investment objectives, particular needs, or financial situation. You should consider whether an investment fits your investment objectives, particular needs, and financial situation before making any investment decisions. II ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 6 of 12 October 2007 Dear Readers, Principal Real Estate Investors, Real Estate Research Corporation, and CBRE/Torto Wheaton Research have now collaborated on publishing Expectations & Market Realities in Real Estate for 5 years. We launched our joint effort with the goal of providing a thought-provoking, highly analytical approach to real estate forecasting, with the hope that this publication would prove useful to investors in developing and executing their commercial real estate investment strategies. We are gratified by the positive response we have received from our many readers over the years, and we hope this year’s report will be just as valuable as past reports. Expectations & Market Realities in Real Estate: 2008 – The Caution Flag Comes Out addresses the global credit market turmoil of 2007, which has suddenly and significantly altered both the economic outlook and the investment climate. As noted in our report, the after-effects of the capital market volatility likely will be felt for an extended period of time. Reversing a period of increasing use of financial leverage, both the global credit markets and the commercial real estate markets likely are entering an era of deleveraging, as the aggressiveness of the debt capital markets and the risk appetite of investors downshift. Increased investor caution is critical as the previous environment of mostly upside variances in commercial real estate markets, largely driven by cap rate compression, has given way to a heightened risk of downside variances. While the re-pricing of risk in the broader capital markets will create investor uncertainty over the short term, it is a favorable development from the perspective of the long-term health and viability of the real estate markets. If commercial real estate is able to weather the credit market storm and continue to perform well relative to other asset classes, as we expect it will, the asset class will be quite deserving of an increasingly prominent and integral role in the institutional and retail asset allocation mix. Thank you to all who have contributed to this report, including research survey respondents, board members, research analysts, economists, reviewers, and the many others who have shared information. We also thank you – our readers, clients, and consultants – for your interest, and we hope you find Expectations & Market Realities in Real Estate: 2008 – The Caution Flag Comes Out a useful tool and insightful guide as you steer clear of hazards on an increasingly treacherous real estate racetrack. Sincerely, Randall C. Mundt President and Chief Investment Officer Principal Real Estate Investors Kenneth P. Riggs, Jr., CFA®, CRE, FRICS President and CEO Real Estate Research Corporation Raymond G. Torto, Ph.D., CRE Principal and Chief Strategist CBRE/Torto Wheaton Research ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. III Case 4:10-cv-00198-RP -TJS Document 77-16 Sponsoring Firms & Chairs Randall C. Mundt Principal Real Estate Investors Kenneth P. Riggs, Jr., CFA®, CRE Real Estate Research Corporation Raymond G. Torto, Ph.D., CRE CBRE/Torto Wheaton Research Contributing Authors Barb Bush Real Estate Research Corporation Chris Cannon CBRE/Torto Wheaton Research James Costello CBRE/Torto Wheaton Research Todd Everett Principal Real Estate Investors Jim Fitzgerald Principal Real Estate Investors Jason Haigh Principal Real Estate Investors Arthur Jones CBRE/Torto Wheaton Research Del Kendall Real Estate Research Corporation Tony Kenkel Principal Real Estate Investors Abigail Marks CBRE/Torto Wheaton Research Jules H. Marling, I I I Real Estate Research Corporation Gleb Nechayev CBRE/Torto Wheaton Research Ben Neil Real Estate Research Corporation Marc Peterson Principal Real Estate Investors Greg Philipp Real Estate Research Corporation Madhan Rengarajan Principal Real Estate Investors Matt Richmond Principal Real Estate Investors Kelly Rush Principal Real Estate Investors Umair Shams CBRE/Torto Wheaton Research Jon Southard CBRE/Torto Wheaton Research Luciana Suran CBRE/Torto Wheaton Research Karen Van Hamme Principal Real Estate Investors Brian Velky Real Estate Research Corporation Rod Vogel Principal Real Estate Investors Andy Warren Principal Real Estate Investors Dick Waugh Principal Global Investors Filed 08/06/10 Page 7 of 12 We wish to thank these collaborators who were instrumental to the production of this publication: RERC Editorial Board: Stephen Blank Urban Land Institute David Blankenship AEGON USA Realty Advisors, Inc. Nicholas G. Buss I NVESCO Real Estate Susanne Cannon DePaul University – The Real Estate Center Geoffrey Dohrmann Institutional Real Estate, Inc. Stephen Furnary I NG Clarion Partners David Geltner M IT Center for Real Estate Michael Giliberto JPMorgan Asset Management Jacques Gordon LaSalle Investment Management, Inc. Steven Graves Principal Real Estate Investors Wylie Greig I PD - U.S. John Levy John B. Levy & Company Charles Lowrey Prudential Real Estate Investors Mary Ludgin Heitman Capital Management, LLC Dennis Martin RREEF/DB Real Estate John McMahan McMahan Real Estate Services, LLC Glenn Mueller University of Denver Scott Muldavin The Muldavin Company, Inc. Joseph Pagliari University of Chicago Lawrence Raiman Credit Suisse First Boston Richard Sokolov Simon Property Group Allan Sweet AML I Residential Properties, LLC Brian Webb UBS AgriVest, LLC James R. Webb Cleveland State University Charles Wurtzebach Henderson Investors North America, Inc. Sam Zell Equity Group Investments, LLC Design & Layout Lindsay Kalvig Editorial Review & Production Don Burns, Cliff Carlson, Terri Cotter, Karen Halter, Scott Hamerlinck, Michelle Houlgrave, Greg Kendall, Austin MacMullan, Katherine McMahon, Rajiv Sharma, Ashley Smith, Daniel Warner, Jennifer Wilkening IV ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 8 of 12 Executive Summary..........................................................................................................................................................................................2 Chapter 1 The Caution Flag Comes Out.......................................................................................................................................................6 Chapter 2 Downshift in the U.S. Economy..................................................................................................................................................8 Chapter 3 The Global Re-Pricing of Risk: Implications for Real Estate Debt Capital Markets......................................16 Chapter 4 Divergent Paths: Public and Private Real Estate Equity Markets...........................................................................24 Chapter 5 Property Fundamentals: Increasingly Treacherous Conditions on the Track................................................36 Chapter 6 The Road Forward..........................................................................................................................................................................48 Sponsoring Firms............................................................................................................................................................................................54 ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 Filed 08/06/10 Page 9 of 12 ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 The Caution Flag Comes Out After several consecutive years of mostly upside variances in the capital markets, 2007 brought a sudden reminder that downside variances and reversal of investor sentiment can occur quickly and unexpectedly. The commercial real estate markets were swept up in the subprime mortgage and global credit market meltdown, bringing out the yellow caution flag for what may be an extended period of time. Volatility in the real estate capital markets occurred despite reasonably strong underlying space market fundamentals, reinforcing how closely interconnected the real estate markets are with global capital market events, as well as the increased relative size and influence of the public real estate quadrants compared to past cycles. Despite the uncertainty created by the credit market turmoil, increased investor emphasis on risk identification and risk pricing will be a favorable longterm development for the commercial real estate market, following a period of investor risk complacency. Over the short term, however, the real estate asset class will be faced with less-accommodative and more highlypriced debt markets, as well as the risk that financial market turmoil may adversely impact the economy and space market fundamentals. The Economy Although the U.S. economy is still expanding, the risks of recession have increased materially, causing the Federal Reserve to take aggressive action to cut short-term rates. The primary fac- Filed 08/06/10 Page 10 of 12 tors contributing to increased recession risk are the unsettled global credit market and the U.S. housing slump. A recession is by no means a certainty, however, and several sectors of the U.S. economy have the ability to offset slowing consumer spending. Business investment is expected to remain solid, buoyed by recent strong earnings growth and the accumulation of cash reserves that can be deployed into business expansion and inventory rebuilding. A still-strong global economy and a weak dollar support continued export growth, and government spending is likely to increase entering the 2008 election year. Despite slowing job growth, low unemployment rates and continued wage growth should keep consumer spending from going negative. Debt Capital Markets Volatility in the global credit markets spilled over into commercial real estate structured debt markets, creating liquidity problems and causing spreads on commercial mortgage-backed securities (CMBS) to widen to record levels. Demand for CMBS bonds by hedge funds and collateralized debt obligation (CDO) issuers, which had become dominant buyers of securitized products, fell off dramatically at the same time that large volumes of new CMBS supply came on the market, exacerbating the widening of spreads. The suddenness and severity of the volatility in the commercial real estate debt markets demonstrated the force of technical factors to overwhelm stillstrong real estate space market fundamentals. The commercial real estate debt capital markets shifted suddenly from highly accommodative to highly risk-averse. Lenders pulled or restricted warehouse lines, forcing CMBS lenders and highyield debt funds to sharply reduce lending activity. Disruption in the CMBS market opened the door for insurance companies and other portfolio lenders to gain market share, while achieving much higher lending spreads than they had previously. Given the outlook for reasonably strong real estate supply and demand fundamentals in most markets, increases in CMBS delinquency and foreclosure problems should remain low to moderate in 2008 and 2009, barring a recession. CMBS volatility has also created buying opportunities, offering attractive relative value within the fixed-income market as spreads widened considerably relative to similarly rated corporate bonds. As a result, investor interest in CMBS is starting to rebound, and spreads, although still wide by historical measures, have gradually begun to narrow. It is likely that aggressive commercial real estate debt markets have run their course for the foreseeable future, and that the lender caution flag will remain out for an extended period of time. Equity Capital Markets Relative investment performance in the public real estate investment trust (REIT) and private equity real estate quadrants has diverged thus far in 2007, after several years of strong outperformance in both sectors. Despite a rally in REIT share prices since August, bearish sentiment has been a dominant theme in the REIT markets throughout much of 2007, with prices trading at significant discounts to net asset value (NAV) amidst investor concerns about the sustainability of property values and low cap rates. ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 In contrast, private commercial real estate market valuation levels have remained relatively stable thus far. The private equity markets, however, have experienced a change in sentiment, with increasing instances of transaction retrading and seller decisions to delay or pull transactions off the market amidst widening bid-ask spreads. While 2007 will be another record year of transaction volume, most of the momentum occurred early in the year prior to the meltdown in the credit markets, with deal volume expected to be much slower during the rest of the year. The disruption in the capital markets has brought the era of cap rate compression officially to a close, amidst uncertainty as to how the capital markets’ volatility, repricing of debt capital, and shifts in investor risk tolerance will impact cap rates going forward. After several years of increasing financial leverage, it is likely that the commercial real estate markets will transition into an extended period of deleveraging as lenders become less accommodative and upwardly reprice debt capital, especially in the upper reaches of the capital stack. The pace and nature of the deleveraging process will impact the change in the weighted cost of capital, and thus cap rates, going forward. Increased availability of aggressively priced securitized, bridge, and mezzanine debt across the spectrum of property types, quality, and markets over the past few years dramatically reduced investors’ weighted cost of capital, helping to facilitate widespread cap rate compression. However, given much less aggressive debt markets going forward, properties and markets which face the highest incremental cost of equity capital to replace no longer available (or much more costly) debt in the upper part of the capital Filed 08/06/10 Page 11 of 12 stack are the most vulnerable to increases in cap rates. Absent a U.S. recession scenario, however, the continuing weight of capital, still-strong space market fundamentals, and still-high replacement costs provide an underpinning for relative stability in private equity market property valuations. Space Market Fundamentals Property fundamentals maintained their strong rate of improvement through 2006, with all five primary property types experiencing their strongest rent growth in 5 years. However, improvement in property fundamentals has slowed in 2007, and in a few markets, fundamentals have deteriorated. As a result of economic uncertainty and the turmoil in the capital markets, increased investor caution and selectivity regarding space market decisions are warranted. Except for the retail and hotel sectors, the amount of space currently under construction remains relatively constrained. New supply levels in the U.S. have been held in check by high construction costs, making it more challenging to justify new development. Improved market information and transparency, along with the channeling of development capital offshore that might otherwise have been directed into domestic development projects, has also served to keep new supply under control. Office fundamentals, the volume of office transactions, and office pricing levels are entering a period of transition. The pace of office transactions and the aggressiveness of pricing likely will decelerate given much less accommodative lending markets. Mar- ket fundamentals remain strong, but tenant demand has slowed due to both the broader economic slowdown and a tight labor market, causing net absorption to fall slightly below new construction levels. However, vacancy rates are likely to remain moderate, providing positive, albeit slowing, rent growth in most markets. Despite slowing consumer spending and economic growth, the outlook for exports looks strong and will help support continued healthy industrial occupancy levels. However, the continuing new supply of industrial space will lead to less robust rent growth than over the past few years. Valuation levels will get continued support from investors seeking greater exposure to this lower volatility property type. Retail net absorption has been weak in 2007 and combined with significant new supply, has pushed retail vacancy rates up materially since bottoming out in 2005. Although consumer confidence and spending have been buoyed over the past few years by a strong job market, employment growth is beginning to slow. Consumers face both high energy prices and a severe housing slump, which will reduce home equity extraction that previously helped support consumer spending. A key issue affecting retail investment performance is whether a recession can be avoided, keeping unemployment rates low and allowing household income to continue to grow. Apartment fundamentals remain strong, but significant shadow competition lurks in the background in those markets with the most exposure to distressed condominium and singlefamily housing markets. Rent growth is likely to slow relative to the past few years, although apartment occu- ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved. Case 4:10-cv-00198-RP -TJS Document 77-16 pancy levels likely will benefit from strong demographic trends, as well as an expected increase in home foreclosures. The U.S. hotel industry has experienced continued strong operating performance in 2007, although occupancy and growth in average daily rates (ADRs) have begun to moderate as new supply has finally begun to outpace growth in demand. Increased merger and acquisition activity has been occurring over the past several quarters, as rising earnings, steady appreciation of assets, and an abundance of investment capital have attracted investors. However, the change in the debt markets and the maturity of the hotel cycle likely mean that both hotel transaction volume and earnings growth have peaked. The Road Forward Commercial real estate is confronted with a more challenging capital markets environment than it has faced for several years. The real estate markets face three key risks: the risk of broad-based upward pressure on cap rates and a decline in property values; the risk of credit market events leading to a recession; and the longer-term risk of a backlash against globalization and subsequent protectionist legislation that hurts trade activity, long-term economic growth, and ultimately, real estate values. Growing uncertainty is forcing investors to re-evaluate their assumptions regarding rent growth, net absorption, and exit cap rates. This re-evaluation of risk pricing in the private equity real Filed 08/06/10 Page 12 of 12 estate markets means that the previous asymmetric environment of virtually all variances being on the upside will give way to more frequent instances of downside variances. While this will result in some short-term investment performance problems, from a long-term perspective, it is a favorable development for the real estate markets. Downward pressure on values is likely to be most significant in instances where real estate that was priced for absolute perfection is confronted by multiple sources of imperfection. This includes situations where pricing levels were propelled largely by ultra-accommodative debt capital markets, where properties were acquired for prices well above replacement costs, or where properties are located in markets especially vulnerable to deterioration in space market fundamentals as a result of credit market turmoil. Upward pressure on cap rates will also likely be most pronounced in lower quality assets in secondary and tertiary markets, which have benefited the most from overly-aggressive debt capital pricing. Conversely, high quality assets in primary markets, especially supply-constrained markets with strong demographic outlooks, are better-positioned from both a capital re-pricing perspective and from a greater likelihood of sustained earnings growth to help offset upward pressure on cap rates. A recession would be a significant negative for commercial real estate private equity values due to the likelihood of a material deterioration in space market fundamentals relative to current investor assumptions. However, a recession is not necessarily the most likely economic outcome. Consumer spending will no longer be as significant a driver of economic growth, but if unemployment rates stay low, consumer spending should stay positive. Net exports, business spending, government spending, and the Federal Reserve’s shift to more accommodative monetary policy represent powerful forces of economic resiliency and growth. The forces of anti-globalization and protectionism, increasingly visible during the run-up to a presidential election year, represent a long-term risk to the economy and the real estate markets. Protectionist measures likely would diminish the trajectory of potential U.S. economic growth; impair the economic health of metropolitan areas that have become integral to cross-border movement of goods, services, and capital; and add to inflationary pressures, pushing up interest rates. Despite its disruptive effects, market volatility also creates buying opportunities, especially for long-term investors in commercial real estate sectors that are no longer priced for perfection yet continue to have a favorable outlook. In addition, the renewed sense of risk awareness that has resulted from the wake-up call of market volatility will serve the asset class well going forward. Commercial real estate also has the opportunity to demonstrate its relative value and resilience in the face of volatility in the capital markets. If the space markets remain healthy and commercial real estate performs well on a risk-adjusted basis relative to other asset classes as capital markets turmoil begins to subside, commercial real estate’s integral role within institutional and retail investors’ asset allocation mix will be strongly reinforced. ©2007 Principal Real Estate Investors, Real Estate Research Corporation, CBRE/Torto Wheaton Research. All Rights Reserved.
