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March 14, 2014

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RCLCO U.S. Real Estate Chart Book - March 2014

By: Paige Mueller, Managing Director

RCLCO U.S. Real Estate Outlook

U.S. real estate markets continue to improve with generally higher occupancy and rental rates across most property types and markets. Capital continues to flow into the sector with record fundraising by REITs in 2013 and banks again lending at a pace that is faster than the number of loans that are maturing. Pricing in secondary markets has been improving at a similar pace as the primary markets since late 2011, evidence of increased risk tolerance by investors. This has also particularly benefited private equity firms and others who have been successful in raising value-add and opportunistic funds recently.

We are encouraging clients to think through their long-term cycle strategies now while fundamentals are generally positive. Cycle strategies should set a long-term framework and action plan through which real estate firms can operate successfully during all parts of the cycle. Part of this strategy should identify key market indicators and plans that can be enacted when those indicators begin to change / appear in the market. The plan should be in effect during all phases of the cycle—and if it does not exist, should go into effect now as it requires some advance planning and agreement as to action plans among senior members of the firm. We have seen evidence from the last cycle that firms who had such plans in place were able to invest and sell more thoughtfully as market conditions began to change, and thus had better performance metrics.

For example, higher occupancy, rental rates, and pricing are also generating more construction, and this construction is now spreading beyond a few key markets. While this is an indication of positive demand, we are already beginning to see flattening to lower occupancy rates as a result of new supply in a few apartment markets and in D.C. and CBD New York office markets. While this is more of an exception than the rule, it is the start of a more mature phase of the market that will expand to other metro areas as the supply pipeline continues.

In the capital markets, the 100 bp summer increase in 10-year treasury yields has not reversed. While mortgage rates moved in synch with interest rates in 2013, there was no noticeable increase in cap rates, likely because of the relatively wide spread that existed in 2013 between cap rates and interest rates (but is now gone). With long-term inflation expectations remaining just above 2%, we expect that 10-year treasury yields could rise by another 50-100 bp to the 3.5%-4+% range which could put upward pressure on cap rates, particularly in markets or properties with limited potential for future income growth. Thus, in addition to downward pressure on income from new supply, the capital markets could also put downward pressure on return expectations going forward.

The graphs on the following pages are designed to help firms identify key indicators that should inform their cycle plans. While we still see many interesting investment opportunities from core through new development, investors should be carefully reviewing leverage and buy/sell strategies as part of their cycle planning.

To view the chart book, please click here.

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