San Francisco Real Estate: “The Scoop”

Retail property fundamentals are softening due to the prolonged housing downturn and slowing economy; however,

performance variation by market and type of retail has widened significantly. This makes it more critical than any

time since 2002 to base investment strategy on specific markets, submarkets and investment circumstances. In the near

term, the retail sector will continue to feel the strain of reduced consumer confidence, the housing slump, and high food

and energy prices. The credit crunch has brought several planned projects to a halt and will limit speculative shopping

center construction, providing an opportunity to work through excess supply. Mature, supply-constrained markets will

outperform over the next 12 to 18 months as the economy stabilizes and moderate growth resumes. Current weakness

in traditional growth markets, mostly brought on by housing problems, could result in favorable longer-term investments

as these markets recover over the next 24 months.

Similar to other commercial property types, economic uncertainty and tight credit markets are resulting in significant

reductions in retail transaction velocity and mild price correction. Fortunately, the shift that is under way was preceded

by several years of healthy performance and robust price appreciation, which will limit distress sales and prevent

a major marketwide correction. Price and cap rate movements have been highly dependent on asset quality and tenant

credit, with the most sought-after properties experiencing cap rate adjustments ranging from 20 basis points to 40 basis

points. Cap rates for lower-quality properties have increased more substantially, reflecting lenders’ and investors’ focus

on safety. Despite tight credit markets and the considerable reduction in the issuance of commercial mortgage-backed

securities (CMBS), the majority of maturing commercial mortgages are being successfully refinanced and delinquency

rates remain near historical lows.

a technical recession unlikely and should prevent a prolonged downturn, fostering growth later

this year. In addition, companies avoided excessive hiring and capital investments during the

most recent expansion period, supporting expectations for only a moderate downturn.

square feet in 2007. Several large regional malls/lifestyle centers are slated to come online

this year, totaling 11 million square feet, more than two times the total delivered in 2006.

basis point increase in 2007. Absorption of neighborhood/community center space turned negative

in the first quarter of this year for the first time since 1980, though vacancy in this segment

remains below the overall retail average at 7.7 percent.

this year to approximately $20 per square foot, compared to 2.9 percent in 2007. Owners are

expected to increase concessions, limiting effective rent growth to 0.9 percent.

No

change in

total

employment

140 basis

point

increase in

vacancy

131 million

square feet

will be

completed

1.9%

increase in

asking

rents

Retail Index (NRI). The NRI is a snapshot analysis that ranks 43 retail

markets based on a series of forward-looking supply and demand

indicators. Markets are ranked based on their cumulative weighted-average

scores for various indicators, including forecast employment growth, vacancy,

construction, household formation, retail sales, rent growth and an additional

analysis of local housing market conditions. Taking into account both the

forecast level and degree of change for the year, the index is designed to

indicate relative supply and demand conditions at the market level.

Users of the index are cautioned to keep several important points in mind.

First, the NRI is not designed to predict the performance of individual

investments. A carefully chosen investment in the bottom-ranked market

could easily outperform a poor choice in the top-ranked market. Second, the

index is geared toward a short-term time horizon. A market facing difficulties

in the near term may provide excellent long-term prospects, and vice versa.

Third, it is possible for a market to rise in the rankings even if its fundamentals

are weakening. This can happen when conditions fall off more substantially

in the market’s peers. Finally, because the NRI is an ordinal index,

differences in specific rankings should not be misinterpreted. For example, the

top-ranked retail market is not necessarily twice as good as the second-ranked

market, nor is it 10 times better than the 10th-ranked market.

Retailers are feeling the effects of the cooling economy and weak housing

market conditions. Food and energy costs continue to rise, putting a greater

strain on household budgets, while job losses during the first several months

of 2008 have hampered consumer confidence and further restrained discretionary

spending. These trends have been especially apparent in markets that

had posted some of the most impressive gains during the housing boom,

including Phoenix, Riverside-San Bernardino, Las Vegas and several Florida

metros. In many cases, retail developers built ahead of rooftops in outlying

areas of these markets and are now struggling as housing projects are delayed

and residential foreclosures push higher. There is good news in the

marketplace, however. In many supply-constrained areas, fundamentals

remain healthy, despite vacancy rates creeping moderately higher. Home sales

have already begun to pick up in a handful of markets, and modest job growth

is expected to return in the second half of the year, suggesting that the

economic downturn should be short-lived. Finally, retailers could see an

uptick in spending in the next few months as consumers receive tax rebates as

part of the economic stimulus package.

Marcus & Millichap Research Services National Retail Index

In the 2008 NRI, San Francisco ascended seven places to take over the top

position. San Francisco will receive a minimal amount of new stock, keeping

vacancy low enough to drive above-average rent growth. Strong retail sales

and rent gains propelled Seattle (#2) up three places in the index. Completions

are slowing significantly in San Jose (#3), sustaining the vacancy rate well

below the national average and supporting continued rent increases.

Uncertainty in the financial services sector is expected to result in weak job

expansion in New York City, causing the metro to fall three spots to #4, despite

forecasts for some of the nation’s strongest rent growth. High household

incomes will support spending in Washington, D.C., this year, easing the

metro up four spots to the #5 position.

San Diego comes in at #6 again this year, although vacancy will rise in

response to increased retail deliveries. Oakland (#7) fell three spots in the NRI

amid forecasts for net job losses in 2008, though the market is expected to end

the year as the tightest market in the index, even after a vacancy forecast

increase. Portland (#8) made one of the greatest gains in the 2008 NRI, as

metrowide job growth and rent appreciation are expected to outpace the

national average in 2008. Despite some projected job losses, healthy rent

growth moved Los Angeles up three places to #9. Boston rounds out the top

10, jumping eight spots due to a forecast for only a modest increase in vacancy.

Weak housing market conditions drove down some traditionally highgrowth

metro areas in this year’s ranking. Fort Lauderdale (#15), Phoenix

(#19) and West Palm Beach (#21) fell 13, 16 and 10 places, respectively. While

local retail fundamentals in these markets will experience turbulence over the

next 12 to 18 months, forecasts for retail demand drivers remain among the

strongest in the nation, supporting still-favorable long-range outlooks.

Despite forecasts for robust economic growth, Houston (#27) and

Dallas/Fort Worth (#28) declined modestly in this year’s index due to high

levels of construction, which will result in vacancy increases of more than 100

basis points in each market. Austin (#11), on the other hand, rose four spots

due to scaled-back development and a healthy job growth projection.

Midwestern markets make up much of the lower-third of the NRI again

this year, as employment losses will continue to restrict retail sales in these

areas. Since many of these markets did not experience a rapid run-up in home

prices or retail development, they may offer more stable retail fundamentals

through 2008.

National Retail Index Marcus & Millichap Research Services

0

30

60

90

120

0

75

150

225

300

Fed rate cuts, new liquidity measures and tax rebates become more apparent.

The housing market should reach bottom later this year, though risks are

clearly present, including the potential for rising foreclosures outside of the

subprime arena. An estimated 9 million U.S. households have negative equity in

their homes, which could lead many otherwise financially able homeowners to

walk away from their mortgages. If this occurs en masse, a rapid run-up in for-sale

supply could keep downward pressure on prices and extend the housing downturn

into 2009. Fortunately, long-term interest rates are expected to remain relatively low

throughout 2008, while conforming residential mortgage caps have been raised in

higher-priced markets, home starts have dropped off, and government interventions

to stem the pace of foreclosures are expected. Barring additional unexpected

shocks to the credit markets, home buying should pick up in the second half,

reducing for-sale inventory and curtailing price correction in most markets.

Despite a more optimistic economic outlook for the latter half of 2008, many

retailers will continue to shutter underperforming locations, proceeding with

caution through 2009. From 2002 to 2007, U.S. households cashed out $1.3 trillion

in home equity, mitigating the impact of rising energy prices on discretionary

spending. With home prices declining, homeowners are feeling the pressure of

elevated food costs and sky-high gas prices. In addition, a broad-based negative

psychology has spread to businesses and consumers, further restraining

spending. There are some bright spots in the economy, however, including

stronger export demand and international travel. Driven by the dollar’s weakness

against other major currencies, the influx of international travelers will lend

support to the retail sector in several gateway markets.

were relatively lean heading into the current downturn, and wage pressures

should ease further this year. Net job losses were reported through the first

several months of 2008, but hiring is anticipated to resume in the second half,

resulting in a flat employment market this year.

2008, compared with 2.2 percent in 2007, as growth in the second half offsets

contraction earlier in the year. The weak dollar will continue to support

healthy export activity, and corporate balance sheets outside of housing- and

banking-related industries are still sturdy.

of $100 billion in tax rebates. If history repeats itself, roughly two-thirds of

the total will be spent by year end, much of it in the retail sector, which is

good news for struggling merchants.

reached just 2.5 percent over the past year, oil prices have spiked more than

20 percent since year-end 2007. Higher production costs will eventually need

to be passed along to consumers, increasing the likelihood of Fed tightening

following normalization of the economy.

contributed $6.4 trillion to U.S. households’ net worth from 2002 to 2006;

however, the trend has reversed, with housing subtracting nearly $180

billion during the second half of 2007.

* Forecast

Marcus & Millichap Research Services National Economy

* Forecast

8.7 9.7

11.1 11.8

5.5 5.8

7.4 8.3

8.3 9.2

11.3 13.3

8.9 10.7

11.2 11.8

14.3 15.6

7.3 8.1

9.8 11.4

5.9 8.4

11.3 12.5

11.5 12.8

8.6 9.6

10.8 12.0

4.9 6.5

7.3 8.1

5.7 6.8

10.1 11.7

9.0 9.6

7.9 9.0

5.1 5.7

4.2 4.9

2.0 3.1

4.7 5.6

8.1 8.6

6.7 7.4

8.1 10.3

5.5 6.3

11.6 13.8

8.9 10.7

9.6 10.4

13.3 15.1

3.1 3.8

4.0 4.3

3.2 4.3

7.7 8.3

10.1 10.8

7.7 9.5

9.1 11.3

3.9 4.6

7.2 8.6

17.37 17.56

19.87 20.51

21.55 21.87

17.78 18.35

19.65 20.00

14.58 14.75

15.39 15.31

12.63 12.71

15.65 15.70

17.17 17.44

17.56 17.49

19.33 19.27

15.74 16.02

15.01 15.09

15.54 15.85

14.02 14.20

23.65 24.03

29.59 30.42

24.29 25.21

15.26 15.31

17.83 18.26

21.64 22.08

68.19 71.00

27.96 28.63

29.09 29.41

31.58 32.09

18.64 18.88

19.92 20.20

19.36 19.48

19.67 20.32

22.40 22.53

23.87 24.04

16.27 16.51

14.83 15.10

28.91 29.43

33.57 34.38

31.58 32.27

22.73 23.61

15.09 15.30

15.68 15.79

17.31 17.64

27.34 28.00

22.87 22.98

6,032 4,900

5,331 2,000

1,917 2,100

3,356 1,700

9,100 5,100

2,216 1,600

1,919 1,600

1,235 1,200

9,232 5,100

4,444 2,500

2,700 1,400

1,893 1,000

4,029 10,300

1,871 2,500

3,614 1,400

1,402 3,300

2,626 3,300

3,359 3,000

2,166 1,600

787 1,300

3,779 2,200

376 500

1,200 1,300

1,100 3,500

862 900

1,253 1,100

3,813 2,800

1,765 1,600

7,495 7,500

1,420 1,250

5,831 6,800

2,015 1,900

1,921 1,100

3,961 3,700

784 1,400

366 100

883 250

1,404 2,650

2,557 1,900

2,873 3,300

198 2,000

2,635 4,000

1,373 750

1.6 0.9

3.4 2.2

0.6 0.5

2.9 0.5

0.5 0.1

0.9 -0.8

-0.4 -0.7

1.2 -0.4

2.6 1.3

2.2 1.0

-1.8 -1.0

-0.2 -1.1

3.9 1.9

1.2 0.4

0.4 0.5

1.8 -0.2

0.3 -0.6

0.1 -0.2

0.6 0.1

0.1 -0.7

0.5 0.3

-0.5 -0.4

0.9 0.1

0.5 0.0

0.1 -0.8

-1.5 -0.7

1.0 0.2

0.6 0.1

0.2 -0.3

1.7 0.4

-0.4 -1.0

0.5 -0.4

3.2 1.6

2.3 1.9

0.3 -0.6

2.1 1.0

1.6 0.7

2.9 1.9

0.2 -0.1

-1.2 -0.4

-0.7 -0.8

0.8 0.4

-0.6 -0.7

Statistical Summary Marcus & Millichap Research Services

1 See Statistical Summary Note on page 8

* Forecast

moderating retail sales growth and store closures will have on retail

property performance this year. Nonetheless, vacancy rose 40 basis points

in the first quarter to 10.1 percent, and further increases are anticipated amid

scaled-back expansion plans and closures of underperforming locations. The

disappointing holiday season, slower retail sales and tighter credit markets led

to the closure of 2,125 stores during the first quarter, two-thirds of the total

reported during the first half of 2007. For the year, closures are forecast to total

6,000 stores, which would be the highest figure since 2004; however, retailers left

standing this year should be well positioned to resume expansion when the

economy stabilizes and housing regains some traction. Retailers of nonessentials

are taking the hardest hits, with apparel and furniture stores recording the most

significant year-over-year declines in sales. Drugstores and wholesale clubs are

faring best in the current climate as consumers respond to slower economic

growth by seeking lower prices and focusing on everyday necessities rather

than luxury items.

The housing downturn and overall economic slowdown have generated

significant financing challenges for mixed-use developers, causing delays and

sending some builders back to the drawing board. As this year advances, the

tighter credit environment will result in further reductions in speculative retail

development, easing supply-side concerns in markets that face short-term overbuilding

issues. At the same time, some regional mall owners are breathing new

life into dying properties by signing nontraditional anchor tenants. Department

store consolidation and changing consumer preferences have pushed many welllocated

infill mall properties to the brink, providing strong opportunities for

expanding retailers such as Costco and Trader Joe’s to pick up mall space in

quality locations.

are forecast at 131 million square feet this year, down from 145 million

square feet in 2007. Several large regional malls/lifestyle centers are slated

to come online, totaling 11 million square feet, more than two times the total

delivered in 2006.

to 11.1 percent, following a 90 basis point increase in 2007. Absorption of

neighborhood/community center space turned negative in the first quarter

of this year for the first time since 1980, though vacancy in this segment

remains below the overall retail average at 7.7 percent.

asking rents are forecast to rise 1.9 percent this year to approximately $20 per

square foot, compared to a 2.9 percent gain in 2007. With vacancy edging

higher, owners are expected to increase concessions, limiting effective rent

growth to 0.9 percent.

that once boasted the hottest housing markets are now experiencing the

greatest increases in retail vacancy, as many new home developments failed

to materialize and a large share of new houses remain vacant. Fortunately,

these metro areas have some of the most promising long-term household

and employment growth forecasts in the nation.

Marcus & Millichap Research Services National Retail Overview

hindered transaction velocity so far this year, with retail property sales

down 40 percent during the first quarter compared to one year earlier. The

$1 million to $10 million segment of the market registered only a modest decline,

as private investors focused on single-tenant assets occupied by strong credit

tenants. In addition, the lack of CMBS debt capital is having the least effect on the

lower price ranges, where investors have generally relied on funding from

regional and local banks. Sales velocity in the $40 million-plus price range

declined dramatically upon the onset of the credit crunch and was down nearly

85 percent during the first quarter from one year earlier. Furthermore, foreign

capital flows into the U.S. retail sector surged early last year, dominated by

Australia-based Centro Properties, which recently ran into significant challenges

refinancing its maturing debt. A mass selloff of the 700-property U.S. portfolio

appears unlikely for now, however, as Centro reportedly reached an agreement

with its lenders in early May for an extension through mid-December 2008.

Retail cap rates vary significantly, with assets in primary markets registering

a mild 10 basis point uptick to 6 percent during the past year, while cap rates in

secondary/tertiary markets have increased 50 basis points on average to the mid-

6 percent to low-7 percent range. Investors’ focus on safety and tighter lending

standards have also affected cap rates for multi-tenant assets, with the average

rising 50 basis points to 7.6 percent. Quality shopping centers in primary areas

continue to command interest from multiple buyers. Concerns over the depth and

duration of the economic downturn and the health of retailers, however, are

driving up cap rate expectations as related to upcoming lease expirations.

that meet their investment strategies would be wise to leverage the current

market environment and still-attractive financing to increase their holdings.

Although pricing and cap rates are adjusting by property quality, strength of

rent rolls and the local market, the number of distressed sales in the marketplace

is unlikely to present substantial across-the-board price reductions.

foreign acquisitions of major U.S. retail properties accounted for roughly 10

percent of total dollar volume, compared with 17 percent in 2007, and the

sources of capital have shifted. Australian investors have been nearly absent

from the marketplace thus far in 2008 after accounting for 85 percent of

foreign investment in U.S. retail last year, replaced by European investors

who are driven by highly favorable exchange rates and comparatively

attractive yields.

retail property returns remain attractive, both from a short- and long-term

perspective. Over the past year, total returns on retail properties reached 15

percent, falling short of office but surpassing the S&P 500 by a wide margin.

from 2002 to 2006, retail prices are retreating moderately. Price correction is

concentrated in the lower tiers, which experienced some dramatic cap rate

compression in recent years. The cap rate spread between primary and

tertiary markets has expanded to more than 100 basis points and is forecast

to widen further as investors and lenders lean toward safety.

* 12 Months Ending 1Q 2008

Investment Outlook Marcus & Millichap Research Services

0%

2%

4%

6%

8%

some balance-sheet lenders reached capacity and retail market fundamentals

softened. Borrowers’ and tenants’ credit qualities are under close scrutiny,

which, along with property location and quality, is driving lenders’ decisions.

Loan-to-values (LTVs) have decreased over the past year at an average of 60

percent to 70 percent; however, LTVs today are closer to historical averages than

the aggressive levels of 2006 and early 2007, when borrowers could obtain loans of

80 percent or more. Debt-service coverage ratios (DSCRs) also reflect greater

caution in the marketplace, with lenders requiring 1.25x, compared with 1.1x or

break-even in some cases. Obtaining financing for lower-quality assets occupied by

noncredit tenants, or those that rely heavily on future rent and occupancy growth,

has become increasingly challenging. On a positive note, delinquency rates for

retail mortgages are still near historical lows, and despite constraints on debt

capital, the majority of maturing loans are being successfully refinanced.

While financing is tighter, debt capital is available for realistically priced

assets. Portfolio lender spreads for anchored retail properties are currently 210

basis points to 300 basis points over the 10-year Treasury, depending on the type

of retailer and the buyers’ and tenants’ credit qualities. Loans on unanchored

properties are pricing at 240 basis points to 325 basis points over the 10-year

Treasury. As of early May 2008, there were signs of thawing in the previously

frozen conduit market, where retail property loans were being priced at 325 basis

points to 375 basis points over the 10-year Treasury.

to rise further, driven by loans originated in 2006 and 2007, when underwriting

was most lax. At the end of the first quarter, retail CMBS delinquency was

at just 0.25 percent, compared with the overall average of 0.43 percent.

cut the fed funds rate by 275 basis points to its current 2 percent. While the rate

cuts should help to stimulate economic growth in the second half of the year,

a potential side effect is rising inflation, pointing to the likelihood of a

tightening campaign shortly after economic growth returns.

addition to rate cuts and an extension of its term-auction facility in the first

quarter, the Fed also opened the door for major securities firms to borrow

directly from the central bank using difficult-to-trade agency mortgagebacked

securities as collateral. In addition, the Fed extended credit to J.P.

Morgan Chase to support the acquisition of struggling Bear Stearns, staving

off a potential financial sector collapse.

Treasury fell to a low of 3.3 percent in March 2008 but has increased in recent

weeks; however, at 3.9 percent, it is still 135 basis points below last summer’s

peak. Despite the weak dollar and inflation concerns, investors will continue to

look to U.S. Treasury bonds as a safer alternative to stocks, keeping the 10-year

Treasury in the high-3 percent to low-4 percent range this year.

Treasury is a sign that the “run for safety” is losing steam and investors are

regaining some confidence in financial markets. As investors’ confidence in the

economy and credit markets is slowly restored starting in the second half,

lender spreads will begin to narrow.

Statistical Summary Note: Metro-level employment growth is calculated on a year-over-year basis using a fourth quarter average. Vacancy and rents are fourth quarter figures. Annual asking rents exclude concessions.

Marcus & Millichap Research Services Capital Markets

* Through 1Q 2008

Managing Director

Marcus & Millichap Capital Corporation

Tel: (949) 851-3030

whughes@marcusmillichap.com

Prepared and edited by

Senior Analyst Managing Director

Research Services Research Services

Tel: (602) 952-9669 Tel: (925) 953-1700

elinn@marcusmillichap.com hnadji@marcusmillichap.com

Senior Vice President, Managing Director

National Retail Group

Tel: (678) 808-2700

bhaddigan@marcusmillichap.com