U.S. Real Estate Outlook

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1 INSIGHTS U.S. Real Estate Outlook Spring was the worst calendar year for financial markets since the Great Depression and 2009 looks to be one of the worst for the global economy in decades. The fiscal stimulus currently in the works should help cushion the downturn, but it will likely be months before planning and political barriers are cleared and the money is deployed. In the meantime, private sector deleveraging will continue to savage economic growth. National economic outlook J.P. Morgan continues to cut its near-term economic forecasts, such that 2009 is expected to post the worst four-quarter decline in GDP growth since We now expect unemployment to peak at approximately 9.5%. As recently as September (before the collapse of Lehman), our economists expected the peak to be just 6.4%. We still expect a modest GDP recovery starting in the second half of 2009, but such a weak start to 2009 presents downside risks to that expectation. Moreover, with the recession hole getting deeper, the challenges it will create for the early stages of the recovery are becoming more daunting. With unemployment very high, structural budget deficits large and very low business investment there is a threat of deflation and a significant risk that the economy s potential growth rate slips lower. It is thus important not to confuse a return to growth, when it comes, with a return to health. Exhibit 1: Global financial crisis upended expectations Please visit for access to all of our Insights publications. A: Unemployment rate (%) B: Real GDP growth (annualized % change) 9.5% March 27 forecast 6% Forecast 4% 8.5% Jan. 20 forecast 2% 7.5% Nov. 10 forecast 0% 6.5% -2% Sept. 21 forecast -4% 5.5% -6% 4.5% Q1 09 Q2 Q3 Q4 Q Q2 Q3 Q4 Q Q2 Q3 Q4-8% Sources: Bureau of Labor Statistics, Bureau of Economic Analysis, J.P. Morgan. Q1 09 Q2 Q3 Q4 Q Q2 Q3 Q4 Q Q2 Q3 Q4

2 U.S. Real Estate Outlook Capital market outlook Even before the fourth quarter of 20, debt capital supplied to the commercial property market was scarce. CMBS mortgage loan originations had already collapsed by 97% to just $8.1bn from $238.8bn the year before and total originations had fallen by 57%. When economic conditions worsened dramatically in early October, debt capital for non-apartment transactions became virtually unavailable. As a consequence, the dollar volume of privately negotiated commercial real estate transactions fell by 80% in 4Q 20 versus already depressed levels in 4Q With so few transactions, it is difficult for us to calculate just one number to describe how much prices have already declined. A repeat sales index of NCREIF index properties showed a 22% decline from its 2Q 2007 peak through December 20, while the broad NCREIF property index, including appraisals, showed 11.5% in depreciation from its peak. So, if you bought during the frothy days of 2007 and sold by the end of last year, your percentage losses might be nearly twice as high as in the case of an appraisalbased value. That gap is due in part to the fact that a large portion of sellers in 4Q were very highly motivated. Unfortunately, asset prices have declined and will continue to do so in the first half of The share of sales that are forced will increase. When the headwinds of higher required returns, tighter credit terms and lower expected property cash flow growth are considered all of which look significantly worse today than they did as recently as the third quarter of 20 property prices likely have an additional 10 20% correction to undergo, with the prospect that many assets bought at the peak may end up losing more than 40% of their value. Exhibit 2: Private real estate market trading volume ($BN) $600 $500 Retail Office $400 Industrial $300 Apartment $200 $100 $0 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec- Source: Real Capital Analytics. December Real Estate Outlook Spring 2009

3 The regional story Nationally, employment, a key driver of real estate demand, has been falling since the end of Distress in the financial sector and a significant slowing of consumer spending followed the housing collapse. In the ensuing global slowdown, domestic and foreign firms alike pared capital investment, curbing the expansion of some tech-heavy U.S. metros that had previously been growing at a healthy pace. By December 20, nearly every state was in recession, reflecting the wide reach of the current downturn. Suburban office markets were early to soften owing to their exposure to housing-related employers as well as their relative lack of supply constraints. Now the contraction of front-office financial operations is impacting Central Business District (CBD) office markets. Employment statistics do not yet reflect the full extent of financial industry fallout in the New York City area, since workers are still counted in payrolls while they are collecting severance payments, and the layoffs keep coming. Financial woes will ripple broadly through the New York regional economy over the next several quarters. The city s office market already is showing signs of rapidly weakening fundamentals. Both Midtown Manhattan and downtown Boston, the Northeast s other major financial hub, experienced vacancy spikes of at least 50 bps in 4Q 20. Vacancy has also risen sharply in the CBDs of Miami, Seattle and Dallas, all of which are highly exposed to finance. Los Angeles Westside, with its large stable of private equity firms, has seen vacancy shoot up 350 bps since the end of All major office markets, including the few metros that may continue to generate positive job growth (such as Washington, DC, set to benefit from hiring related to federal stimulus and oversight programs), are likely to see rents soften in Manhattan will be especially hard hit; there we look for office rents to drop by 25% or more over the next two years. Weakness in the warehouse sector extends well beyond housing bust markets. Imports continue to fall, reducing demand for industrial space serving the ports. Export-related demand was a bright spot for some U.S. warehouse markets, partially offsetting the drop in imports, but weakening global conditions now are curbing the previously robust growth in export volume. In Chicago, where industrial production has plummeted from the heady levels of , the warehouse availability rate has risen 250 bps in the last four quarters. Three other leading industrial markets Atlanta, Dallas-Fort Worth and Los Angeles all recorded sharply Exhibit 3: Deterioration worst in housing markets Change in office vacancy rate from previous year 4Q 20 (%) Decline in vacancy Increase in vacancy Source: Torto Wheaton, J.P. Morgan Asset Management. Exhibit 4: Warehouse weakness spreads well beyond housing bust markets Change in availability for warehouse properties from previous year 4Q New York Washington, DC Chicago Los Angeles Boston Dallas Houston Atlanta Philadelphia Denver San Francisco Seattle Detroit Orange County Phoenix Pittsburgh Oakland San Diego Baltimore Kansas City Newark St. Louis Sacramento Miami Edison Decline in vacancy Increase in vacancy No change Chicago Los Angeles Atlanta Houston Dallas Philadelphia Minneapolis Riverside New York Detroit Cincinnati St. Louis Miami Columbus Edison Orange County Boston Fort Worth Oakland Seattle Newark Kansas City Phoenix Indianapolis Baltimore Source: Torto Wheaton, J.P. Morgan Asset Management. J.P. Morgan Asset Management 3

4 U.S. Real Estate Outlook negative demand in 4Q 20. Southern California s Inland Empire market generated modestly positive absorption through the end of 20, but due to development excesses the Inland Empire has a supply overhang that may take years to work off and which will put a lid on rents for some time. We look for warehouse rents to fall in nearly all major markets in 2009, with Southern California and some of the Florida markets among the worst performers. Houston is likely to be among the best performing markets with relatively stable rents. Weak labor conditions discourage household formation and negatively impact overall residential demand. Limited employment opportunities and difficulty selling one s home to move to another city will tend to stymie migration between metros areas. The majority of apartment markets will see rents fall in 2009, though the dispersion of performance will be significant. Markets with better economic prospects in the near term, and markets that have not seen a large run-up in rents, including the Texas markets, Seattle and Philadelphia, likely will experience only small declines over the coming year. We expect Charlotte, Chicago, New York City, Oakland, Miami and Phoenix to be among the worst performers with rents down 5% or more. The retail sector, a relatively strong performer through the last two recessions, faces grave challenges in a consumer-led downturn. The retail outlook is broadly negative across the U.S. Even in places where the local economy appears stable there is nothing to insulate a shopping center from the fallout associated with a large national retail tenant s bankruptcy, for example Circuit City shuttering 567 stores across the U.S. in a Chapter 7 liquidation. The headwinds of job losses, falling home prices and falling stock prices will hurt everyone, while the potential for disproportionate pain in the high-wage financial sector may exact a large impact on higher-end shopping centers. Exhibit 5: Apartment market weakness spreads Apartment y/y effective rent growth 4Q 20 10% 8% 6% 4% 2% 0% -2% -4% -6% Last year Current year New York Los Angeles Chicago Dallas Houston Miami San Francisco Washington Philadelphia Boston Atlanta San Diego Riverside Detroit Seattle Phoenix Baltimore Minneapolis Sacramento St. Louis MO Tampa Portland Denver San Jose Las Vegas Source: Bureau of Labor Statistics, J.P. Morgan Asset Management. Exhibit 6: Retail more exposed than normal in this downturn Relative tenant demand exposure to macroeconomic conditions Higher exposure Hotel Retail Power Center Retail Mall Office Warehouse Self-Storage Apartment Retail Grocery Anchored Assisted Living Student Housing Medical Office Source: J.P. Morgan Asset Management. 4 Real Estate Outlook Spring 2009

5 Sector views Office Employment in office-using sectors has fallen more rapidly than overall employment. Nationally, office employment declined 3.6% as losses in the financial sector accelerated in 20. For the year, net absorption in the office market was less than 15 million square feet and as such it was one of the weakest years on record in terms of demand. A significant amount of space was shed by banks in the latter months of 20; far more will be freed up over the next several quarters by an ever-broadening range of office-using industries. This redundancy will exert downward pressure on rents over the course of the next two years. The U.S. office vacancy rate was just under 14% as of 4Q 20, up from a cyclical low of 12.5% in In this cycle the office vacancy rate never dipped into the single digits, as it did at the peak of the last cycle in the late 1990s; consequently the market headed into recession with a higher level of existing vacancy than at the start of the last downturn. Even though development activity has been much more contained in this cycle, and it will continue to be muted due to weak demand, falling property values and scarcity of financing, we look for office vacancy to climb higher than it did in the last recession because it was so much higher at the outset this time. We expect that office rents, which expanded at a sub-inflationary pace in 20, will decline through Industrial/Warehouse Warehouses are being punished by the weak consumer economy. Retailers now hold excessive inventories of bulky goods, such as furniture and home furnishings as well as building materials and garden equipment. Judging by their inventory to sales ratios, these retail categories are carrying inventories about 12% above the level justified by current sales. Nationally, the warehouse availability rate has been rising for five consecutive quarters. In 4Q 20, the amount of occupied warehouse space fell by 27 million square feet, pushing the availability rate up 60bps to 11.8%. With the recession deepening, we expect virtually all major markets to experience negative net absorption in Nationally, availability will rise well past the last cyclical peak of 12.1% in 2003 even though, as in the case of the office sector, the supply side will continue to be muted. Recessions historically have been associated with sharp drops in industrial rents. Rents fell in 20 and we anticipate that, like office rents, they will continue to decline through Exhibit 7: Other shoe to drop: Occupancy will react to office job declines Quarterly growth (annual rate) 8% -4% Exhibit 8: Inventory/Sales ratios too high for bulky goods % -10% -12% Source: Real Capital Analytics. December % 4% 2% 0% -2% -8% Furniture & home furnishings Building materials and garden equipment Office occupancy Office employment Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec Source: Bureau of Labor Statistics, J.P. Morgan Asset Management. J.P. Morgan Asset Management 09 5

6 U.S. Real Estate Outlook Retail While no commercial real estate sector broadly overbuilt in this cycle, retail built the most. The problem of oversupply now is compounded by very weak demand trends. Retail sales have taken a sharp turn for the worse: for the three months ended January 2009, total sales were down 20% from six months ago on an annualized basis. Consumers have closed their wallets not only to purchases of vehicles and other big-ticket items, but also to a broad range of discretionary goods including apparel, electronics and department-store type merchandise. Bankruptcies and store closings have already accelerated in the merchandise categories most at risk. Sales of non-discretionary items such as health and personal care continue to rise, but more slowly than six months ago. Discounters have been helped by the decline in energy prices which has disproportionately benefited lower-income families, and by a trading down by higher-income families. The luxury department stores and carriage-trade retailers that sailed through the last recession are suffering in this one. Dominant Class A malls have tended in the past to maintain high occupancy through recessions. In the current environment, highly supply constrained enclosed malls with stable apparel retailers may still be the safest retail sector, but safe is very relative. Smaller shopping centers anchored by supermarkets and drugstores may benefit from sales of necessity items, but these centers tend not to be in supply-constrained locations and so have considerable competition; moreover they often have predominantly nondiscretionary inline and out-parcel tenants, which compromises their traditional defensive character. Power centers are in the worst position because they often harbor volatile home furnishings and electronics retailers like the late Circuit City, and frequently are located in low-density neighborhoods with few barriers to new development. Exhibit 9: Hot: Discounters A: Stock and gasoline prices Not: Luxury B: Same-store sales growth (%) 1,800 1,600 1,400 S&P 500 Gas $4.5 $4.0 $ ,200 $ , $2.5 $ $ $1.0 $0.5 $ Wal-Mart Nordstrom Source: BTS, S&P, ICSC. 6 Real Estate Outlook Spring 2009

7 Multifamily In 4Q 20 apartment rents fell on a year-over-year basis for the first time in five years. It was a sharp reversal for the sector, which had benefited from demand from families foreclosed out of their homes or unable to qualify for mortgages under tighter lending guidelines, as well as those who were deferring homeownership until prices stabilized. Now a worsening economy is taking a toll on household formation, reducing demand for all types of housing, not just apartments. At times like this, people double up with roommates or move back in with their parents to save money. We look for apartment rents to decline through 2009, stabilizing by the end of While housing market conditions vary quite a bit across the country, we think that broad based weakness in the U.S. economy will have a dampening effect on apartment rents in virtually every major market in the U.S. Moreover, the rising volume of auction sales of homes to investors will raise the supply of houses available to rent, competing with apartments for limited tenant demand. Exhibit 10: The for-sale home overhang burdens apartment rentals Empty for-sale housing units plus unsold inventory of builders (millions of units) Sep- Sep- Sep- Sep Sources: Bureau of the Census, J.P. Morgan Asset Management. Sep- 07 Sep- J.P. Morgan Asset Management 7

8 Contributors U.S. Real Estate Research Dave Esrig, CFA Anne R. Hoagland Brian A. Nottage, Ph.D. Luigi B. Cerreta, CFA Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. Certain information contained in this white paper constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as may, will, should, expect, anticipate, project, estimate, intend, continue, or believe, or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance may differ materially from those reflected or contemplated in such forward-looking statements. RISKS: Real estate investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. 245 Park Avenue, New York, NY JPMorgan Chase & Co.