A 2015 CohnReznick LLP Report

MOMENTUM 2015Commercial Real Estate

Outlook

mo • men • tumnoun: impetus and driving force gained by the development of a process or course of events

Regulatory Issues ...6

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Table ofContents

The State of the Market ..............................................................1

Capital Flows ...............................................................................6

Regulatory Issues .........................................................................7

The Road Ahead .........................................................................9

Regulatory Issues ...6

In our preface to last year’s edition of Momentum, we stated our belief that the commercial real estate industry was in a period of great fl ux. Now, one year later, that dynamic energy continues, but at a more deliberate pace. There is no shortage of investor capital or enthusiasm. But the land rush of the last two years has evolved into an environment where we can begin to see the emergence of supply-demand constraints. While there is still plenty of opportunity ahead, there will be a heightened differentiation among market players, with an even greater emphasis placed on strategic acumen and operational savvy. We also believe that market discipline, and having the processes in place to adhere to it, will be a competitive advantage.

On the following pages, the members of CohnReznick’s National Commercial Real EstateIndustry Practice offer their perspectives on what they see as the most notable trends and takeaways at this point in the market’s trajectory, examining the landscape from the perspective of capital fl ows, investors, developers, property classes, and regulatory developments.

We hope you fi nd Momentum 2015: Commercial Real Estate Outlook to be a thought-provoking commentary on the state of the industry and helpful to you as you seek to plot your own course. We look forward to your comments.

David KesslerPartner, National Commercial Real EstateIndustry Practice Director

Preface

February 2015

David Kessler

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The current commercial real estate market, which began 2014 strong and ended it stronger, is fueled by the twin forces of large amounts of available capital seeking returns and fundamental changes in how Americans live and work. The downturn magnifi ed both forces, as capital sat on the sidelines and the need for offi ces, multifamily residences, retail spaces, and industrial facilities re-imagined for the 21st century went unmet. What we have seen in the past two years is the resolution of these tensions.

As we enter 2015, however, the market is moving into a slightly less exuberant, more measured and mature phase. For some areas and asset classes, supply-demand equilibrium is moving back into view and the low-hanging fruit has been picked over. To get a better idea of the many forces at work, we can examine the industry both from the perspective of those doing the investing and of the investments being made.

InvestorsOne of the characteristics of the commercial real estate rebound underway for the last three years is the extent to which it has been driven by private equity. More than just an investor class, private equity funds have become the primary gateway for capital looking to fl ow into the sector, in the same way that REITs, both public and private, were the vehicle of choice following the savings and loan crisis of the 1980s. The difference this time is the size of the institutions involved—both the funds themselves and the entities investing in those funds.

As the industry’s recovery has unfolded, the emphasis on size continues. Even though more small funds are launching than ever before, they are having a harder time raising capital for three distinct reasons. The fi rst is simply the inevitable challenge in any crowded market of rising above the noise. Second, institutional investors have become so large that a fund doing its fi rst $100 million raise will simply be off the radar. Finally, the large funds have generated suffi ciently impressive results that smaller funds have a diffi cult time proving how they can do incrementally better—let alone so much better as to justify the increased risk that investments in smaller funds naturally entail.

The State of the Market

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A recovery led by large investors carries certain implications; not all money is created equal. First, it has led to a notable emphasis on transparency. General partners are held to much stricter reporting standards than they were before the downturn, and thus funds have spent considerable energy improving their accounting functions to get a clearer, more robust view of the health of their holdings, and fund investors evaluate fund managers with greater scrutiny. The injection of healthy skepticism that comes with the capital raised and ultimately deployed is one of the critical factors that has made the real estate turnaround as solid as it has been.

But virtuousness comes naturally when good deals are easy to find; discipline is tougher to maintain when high-value opportunities become scarce. Investors thus will find themselves tested under 2015’s more mature market conditions. From our conversations with leading fund managers and investors, we have identified three strategies forward-thinking market participants can take as we move into the next inning of commercial real estate’s recovery:

Embrace analytics. Most funds and investors have more robust accounting processes than they did five years ago, making for greater transparency and due diligence. But as important as these things are, they only scratch the surface of what can be done with reliable data. Data can be modeled to tell you not just where you have been but where you are going. The advent of predictive analytics in commercial real

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estate means that investors and developers will have powerful new real-time tools to use when plotting strategy and making investment decisions. How likely is it for a given emerging neighborhood to fl ourish? Which type of amenities will result in the lowest tenant turnover and allow for the greatest rent premiums? Where are cap rates headed for this particular property asset?

A new generation of analytic tools is being developed to answer these questions. But technological horsepower will not be enough. Integrating those applications into sound decision making will require investors to revisit and refi ne the models on which they currently rely. More importantly, harnessing the power of analytics will demand a cultural shift at many fi rms. The real estate industry has traditionally had an uneasy relationship with technology. This is partially because technology has often been seen as an expense that diverts resources from the core business, but even more so because it is at odds with real estate’s legacy as a business grounded in instinct and experience. Many of the industry’s leaders are the children—and sometimes grandchildren—of old-school developers who learned the trade by “smelling dirt.” Embracing analytics will require a worldview that integrates algorithmic power with gut feel.

Rationalize operations. Making good investment decisions is only half of the real estate success equation. The other is sound operations that both minimize cost and maximize capital appreciation. Too many general partners treat operations as a purely local matter. While local knowledge is important, failing to look across the entire portfolio represents a wasted opportunity to reduce costs through economies of scale and greater negotiating leverage with suppliers, to identify trends that can help anticipate problems, and to solidify learning and best practices throughout the organization. Maximizing operations may not be as exciting as fi nding and getting a deal done, but it has the potential to generate recurring impact on the bottom line all the same.

Making good investment decisions is only half of the real estate success equation. The other is sound operations that both minimize cost and maximize capital appreciation.

Expand horizons. As the next section discusses in detail, while it may appear that the low-hanging fruit has all but disappeared, it is important to remember that it is only the most exclusive sections of the orchard that have been picked over. Investors are now moving into new geographic areas and new asset types, meeting both the needs of the businesses and individuals outside the high end of the market, as well as their own return expectations.

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PropertiesYes, it is harder to fi nd compelling deals with Class A offi ce buildings, high-end multifamily properties or luxury boutique hotels in primary markets. Madison Avenue, Wilshire Boulevard, and North Michigan Avenue are only so long, after all. But there is plenty of room in the middle. Class B/C+ buildings, moderately priced apartment buildings, and select-service lodging are presenting opportunity—and are, in fact, poised to become the next hot property categories. Witness, for example, the recent rise of REITs focused on senior-living facilities. Similarly, developers and investors are increasing their focus on not just secondary but tertiary markets or looking outside the core areas of primary markets to place bets on promising but heretofore marginal neighborhoods, particularly where new market tax credits and/or historic preservation tax credits are available. Indeed, investors are now net sellers in primary markets, with REITs and core funds content to pick up trophy properties even if cap rates continue to compress.

This progression, of course, mirrors the evolution of the recovery, which unfolded at the top of the economic pyramid and only recently began to reach the middle class. But now that it has, there is increased need for properties targeted toward that segment of the economy. In addition, the ongoing attractions of repurposing will ramp up competition further, as, for example, some investors seek B/C+ offi ce buildings to renovate and attract a stronger tenant base, while others seek to turn them into condos and retail.

Class B/C+ buildings, moderately priced apartment buildings, and select-service lodging are presentingopportunity—and are, in fact, poised to become the next hot property categories.

In addition, the last several years have seen more secondary markets come into their own. As primary markets have become more expensive, young and talented workers have migrated to places like Denver and Charlotte, giving those secondary markets a critical mass of human capital that makes them less dependent on single industries, and thus less vulnerable to economic fl uctuation. This in turn attracts more residents and more investment in a virtuous development cycle.

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Within this larger framework, it will be interesting to see how a number of scrutinized categories fare:

Multifamily: This class has remained the darling of investors; perhaps because of that, there has been running speculation regarding how close we are to the top of the market—and, in fact, one can see signs in certain markets, such as one or two months free rent for new tenants, that supply has caught up to demand. The more interesting question is the direction of the market over the long term. So far, the millennial generation has looked skeptically of traditional benchmarks of adulthood like home ownership. (And not just home ownership—Detroit is spending considerable energy trying to infuse them with the same feelings about

car ownership that their boomer parents had.) If millennials visiting their parents for the holidays start looking wistfully at the psychological and financial equity their parents have built—and if lenders start adapting mortgage screening criteria to take into account millennials’ penchant for frequent job hopping, if not self-employment—the multifamily boom could lose a powerful fundamental driver.

Retail: Here the signals are decidedly mixed. On the one hand, the sector continues to struggle in the face of a high level of retail density, as witnessed by the dozens of dead or dying malls across the country. At the same time, both upscale town centers and neighborhood centers in vibrant residential areas continue to thrive. The takeaway is that to be successful, retail needs to offer more than merchandise. It must either provide a compelling experience, or function as an essential neighborhood resource. One economic indicator to monitor is the price of oil. If 2015 ends with oil still in the $50 per barrel range, we can expect a

long-term bump in disposable income that will measurably improve most retail environments.

Industrial: The sector has gotten increased attention from investors due to the resurgence of American manufacturing and the need for more extensive distribution and logistics facilities to service ecommerce. Indeed, while in an earlier day vacant industrial properties were typically converted into retail space, today one is just as likely to see a “lateral repurposing” into a distribution center. While the strengthening U.S. economy acts as a tailwind on the industrial sector, the strengthening of the dollar and the economic slowdown hitting key players in the global economy like China and Russia could undercut

the demand for U.S. goods overseas, dampening industrial’s growth.

Mixed use: If mixed use did not already exist, today’s investors and developers would have to invent it in order to meet the demands of both millennials and boomers alike for more or less self-contained pods built for the 18-hour day lifestyle. We expect this asset class to remain strong as both investors and consumers expand into frontier areas. The mixed-use development, after all, is uniquely positioned to act as a foothold that transforms a neighborhood.

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According to industry research fi rm PEI, private equity real estate funds raised $116.03 billion in 2014, just below the post-downturn high of $117.85 billion raised in 2013. On the one hand, this supports a continuing enthusiastic view of commercial real estate—capital continues to fl ow into the industry. On the other hand, 2014 represents a plateau that ends three years of steady growth, and does so far below the 2008 fi gure of $161.37 billion. These statistics are probably the best encapsulation of the spirit of cautious optimism that we see ahead. Furthermore, a number of institutional investors, including California Public Employees’ Retirement System and the Illinois Teachers’ Retirement System, have all increased their real estate investment allocations.

Perhaps the most interesting fi nding when examining capital trends is the increased presence of Asian investors. According to PEI, in 2014 capital from Asian investors accounted for $9.0 billion in investments in 2014—a doubling of the $4.5 billion invested in 2012. While this is further evidence of the attractiveness of commercial real estate as an asset class, it also points to increased competition to deploy that capital at a time when good deals have already become more scarce than they once were.

CapitalFlows

Perhaps the most interesting fi nding when examining capital trends is the increased presence of Asian investors. According to PEI, in 2014 capital from Asian investors accounted for $9.0 billion.

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Last year, the industry braced for the impact of signifi cant regulatory changes. Dodd-Frank rules went into effect that removed the exemption many hedge funds, private equity funds, and asset managers relied upon to avoid registering with the Securities and Exchange Commission as registered investment advisors. Larger funds were expected to shoulder these additional requirements by staffi ng up as necessary, but smaller and midsized funds were thought to fi nd the new compliance regime onerous, perhaps even resulting in consolidation as players sought refuge in scale.

As we look back on the year, the impact of Dodd-Frank on industry momentum can only be called underwhelming. This isn’t to say that compliance does not pose real operational obligations of funds—it does. But not only did the larger funds absorb the new obligations, but so did those elsewhere in the size spectrum. In fact, with more small funds being launched than ever before, it’s hard to claim that regulation has been a deterrent to market entry.

Why did the industry perform so much better on this front than was expected? With the benefi t of hindsight, two factors stand out. First, third-party advisors expanded their services, providing much needed bandwidth and expertise for hire. Second, the new regulations represented the industry’s fi rst potential speed bump since emerging from the global downturn. It seems safe to say that much of the concern that was voiced was due more to a broader anxiety about upsetting the recovery. In the end, the industry’s performance on this front testifi es to its health as much as any fi nancial statement does.

On the debt side, traditional lenders have responded to the Volker Rule’s limitations on investments in alternative asset classes by cherry picking their loans, preferring those with low loan-to-value ratios and reducing their ADC lending. (While there is a movement afoot to lobby the Republican-controlled Congress to ease some underwriting restrictions, that development seems neither likely nor advisable.)

RegulatoryIssues

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Last year also saw a tightening of regulations on foreign investors, as new rules went into effect requiring the U.S. seller to collect the 10% FIRPTA tax, as a way of countering poor (and diffi cult to enforce) compliance by foreign buyers.

Newly emergent private equity debt funds fi ll some of the void in the capital stack. These vehicles are responding not only to the opportunities presented by traditional lending sources hampered by regulation, but are also a response to cap rate compression in primary markets. As it becomes more diffi cult for investors to garner pre-2007 level returns via equity, debt at 12% or 13% looks increasingly attractive—particularly since it come with much lower risk.

Last year also saw a tightening of regulations on foreign investors, as new rules went into effect requiring the U.S. seller to collect the 10% FIRPTA tax, as a way of countering poor (and diffi cult to enforce) compliance by foreign buyers. This effectively raised prices of U.S. real estate by 10%—a penalty that only grew as the dollar gained strength during the year. None of this, however, has dampened foreign appetite for U.S. real estate as a stable asset with a strong record of capital appreciation. Indeed, the fact that the U.S. real estate market is now a truly global market is one reason to continue to be bullish on its future. As one manager of a large Chinese private equity fund said to us, “You like to ask yourselves ‘What inning is the market in?’ But for us, we’ve just gotten our hot dogs and settled into our seats.”

Tax policy, of course, consists of carrots as well as sticks. The EB-5 visa program, in which qualifi ed foreign individuals can receive green cards in exchange for investments in designated rural or high-unemployment urban areas that result in the creation of permanent jobs, has gained increasing momentum in recent years, following efforts to streamline a lengthy application process. However, the program, which must be renewed this year, is coming under increased scrutiny from the Republican-controlled Senate, where the chairmanship of the Judiciary Committee passed from program supporter Patrick Leahy (D-VT) to opponent Chuck Grassley (R-IA). While EB-5 investment is a small part of the overall capital stack, it has provided top-off capital for a broad range

of projects—capital that will have to come from elsewhere if the program is not renewed.

If the EB-5 is under scrutiny, extending the Terrorism Risk Insurance Act received high bipartisan support, having sailed through both chambers and signed by the president less than two weeks after the 114th Congress fi rst convened. The extension keeps the act in place until 2020, providing much-needed federal backstopping to exposure from underwriting insurance for acts of terrorism.

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The RoadAhead

As commercial real estate professionals look ahead to this year and next, they can do so with guarded optimism. The road ahead appears stable. For now, at least, capital on the both the debt and equity side remains plentiful and inexpensive. As long as macro factors such as employment growth, demographic trends, interest rates, and regulation continue to remain stable and positive, we can expect sustained growth across most property sectors and geographies. In many cases, however, that growth will be more modest than it has been during the last two years. The entrepreneurial drive of the industry being what it is, no one expects that those constraints will be quietly accepted. How the industry’s various players react and strategize—and whether or not they continue to hew to the lessons of the recent past—will determine the narrative that gets written a year from now.

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About CohnReznick’s Commercial Real Estate Practice

About CohnReznickCohnReznick LLP is one of the top accounting, tax, and advisory firms in the United States, combining the resources and technical expertise of a national firm with the hands-on, entrepreneurial approach that today’s dynamic business environment demands. Headquartered in New York, NY, and with offices nationwide, CohnReznick serves a large number of diverse industries and offers specialized services for middle market and Fortune 1000 companies, private equity and financial services firms, government contractors, government agencies, and not-for-profit organizations. The Firm, with origins dating back to 1919, has more than 2,700 employees including nearly 300 partners and is a member of Nexia International, a global network of independent accountancy, tax, and business advisors. For more information, visit www.cohnreznick.com.

The CohnReznick Advantage for Commercial Real EstateCohnReznick’s Commercial Real Estate Industry Practice provides a broad array of accounting, audit, tax consulting, tax compliance, and business advisory services across all sectors, operating platforms, and geographic regions. Our pledge to provide commercial real estate clients with senior-level engagement teams and forward thinking, success-oriented strategies is what we call The CohnReznick Advantage.

The CohnReznick Advantage is based on delivering the following benefits to our clients:

• Industry Insights, Optimized Solutions – We proactively advise investors and owners on the current market by anticipating challenges and developing strategies based on a client’s portfolio, investment objectives, and risk profile.

• Transformative Advice – We provide commentary on a broad array of international, federal, state, and local tax issues to help clients navigate complex tax laws and capitalize on relevant tax benefits.

• Responsive Culture – Our streamlined organizational structure enables key engagement team members to provide faster, smarter, more efficient services by empowering them to make decisions and provide hands-on advice.

• Capital Markets Dexterity – Working with CohnReznick Capital Markets Securities, we help our developer clients forge strategic alliances with critical capital sources.

• Proactive, Resourceful Service – We consult regularly with client management to develop effective resolutions to critical issues and ensure expectations are met and documented.

• National with Global Reach – Having worked with commercial real estate clients in all 50 states and internationally, we understand the regulatory requirements and other issues pertinent to specific geographic areas and countries.

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