commercial real estate outlook

MOMENTUM 2016

Commercial Real Estate

OutlookA 2016 CohnReznick LLP Report

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

Regulatory Issues ...6

A CohnReznick Report 3

The Relentless Search for Opportunity ......................................1• Fundraising ............................................................................................ 1• Operations ............................................................................................. 3• Market Sectors ...................................................................................... 6

Conclusion .................................................................................10

Regulatory Issues ...6

Table ofContents

cohnreznick.com

When we surveyed the commercial real estate industry one year ago, we predicted that, in 2015, investor enthusiasm would continue and capital availability would remain high. We also thought that the market would be increasingly defi ned by insuffi cient supply with industry participants needing to leverage strategic acumen, operational savvy, and investment discipline to move ahead.

As we believe this 2016 Commercial Real Estate Outlook shows, our forecast was accurate. In looking at the market now, we see the relentless search for opportunity to be the dominant theme. The continued quest to create work/play/live communities has brought life back to the suburbs. Foreign investors seek safe havens in partnering with smaller funds focused on secondary and tertiary markets. Other investors, confronted with ongoing cap rate compression, are redefi ning “real estate” to include cell phone towers and outdoor advertising. All of this activity bodes well—not just because it demonstrates the industry’s famous entrepreneurialism, but because it illustrates that the lessons of the past have not been forgotten. Supply constraints have not caused bubbles, but rather the discovery of new areas of opportunity.

On the following pages, the members of CohnReznick’s National Commercial Real Estate Industry Practice share their perspectives on how they see various key areas of this dynamic market developing, as well as strategies and tactics to consider as you plot your course for the year.

We hope you fi nd Momentum 2016: Commercial Real Estate Outlook to be a useful guide to the state of the industry and look forward to your comments.

David KesslerPartnerNational Director, Commercial Real Estate Industry Practice

Preface

February 2016

David Kessler


Fundraising

Last year proved to be another strong fundraising year, with $108 billion raised in the fi rst three quarters of the year representing a 14% rise over the same period in 2014. The move toward mega funds continues. The 41 funds that closed in the third quarter did so with an average fund size of $1.3 billion.1 Among our fund clients, North American funds held the spotlight with global funds in a close second. In terms of strategy, opportunistic and value-added funds continued to do particularly well, refl ecting the forces discussed in this report that we see driving much of today’s commercial real estate activity.

In other words, the industry continues its upward path. The question is, for how long? The Federal Reserve’s interest rate increase was both modest and

TheRelentless Search for

Opportunity

1PERE Q3 Fundraising Report, p.3.

completely expected. There is a line of thinking that suggests that the fi rst rate increase after a downturn starts a two-year countdown to the next market peak. But such generalizations need to be measured against the specifi cs of the environment. This includes capital fl ows, the overall health of the economy, employment, political stability (and instability), and pervasive, ongoing demographic trends. The fact is that the fundamentals for commercial real estate across all sectors remain strong. The overall health of the U.S. economy is improving. There is a great deal of capital that needs to be deployed and a limited range of investment options. Most importantly, there continues to be a wealth of opportunity for commercial real estate to reconfi gure existing properties to meet fundamental changes in how people live, work, and play.

Momentum 2016: Commercial Real Estate Outlook2

Inbound Foreign InvestorsThe U.S. real estate market continues to be a very attractive safe haven for foreign investors. This trend will only continue throughout 2016 and well into next year as the easing of certain FIRPTA requirements goes into effect.

Many of our smaller fund clients that are looking to move up to the mid-tier bracket are partnering with small or midsized banks or foreign syndicates looking to make their fi rst U.S. investments. For these investors, repositioning multifamily properties or offi ce buildings are particularly attractive. It is our view that there is tremendous untapped potential in bringing together smaller foreign entities with their U.S. counterparts to do deals in the $30 million to $300 million range. These may be deals that are too large for a small U.S. fund to do on its own, and too small to warrant the attention of a larger player. The foreign bank or fund can offer their investors off-market deals with a more appealing return possibility than those investors could get by investing with larger funds or REITs. Further, the U.S. fund gets the critical mass needed to move to the next level.

Bringing more of these cross-border pairings together—for example, bringing a midsized Kuwaiti bank together with a $25 million friends-and-family fund based in Atlanta seeking a deal in Nashville— calls for two things. First, bridges need to be built between networks that simply don’t have many points of overlap. For both sides, then, the key comes down to making a conscious effort to tap into new networks and then having the patience needed for those networks to form.

Second, both sides must be able to work together to identify and structure deals that have enough headroom to allow the dealmakers to get paid, and for the individual investors to get a better return than they would get by investing the capital with a REIT. Foremost here is deep local knowledge on the part of the U.S. fund.

As an additional note, U.S. funds in discussion with Middle Eastern investors might want to encourage them to increase their capacity for development risk, which investors from this part of the world typically

shy away from. The problem is that there are only so many garden apartment complexes in need of upgrading, particularly now that this sub-class has caught the attention of the large investors. Aversion to development—combined with Sharia restrictions that eliminate malls, hotels, and other sizable categories—closes a considerable number of doors. Taking on development will open a few of these doors, allowing for a greater number of deals to go through.

Regulation A+One of the more colorful developments in the investment capital stack is Regulation A+, which was passed as part of the JOBS Act and went into effect this past October. The new regulation allows for the crowdfunding of a wide range of investments, including real estate, up to a $50 million Tier 2 limit, which would certainly go a long way on crowd funding deals where the equity requirement could be $2 to $5 million.

How, and how much, Regulation A+ will be used for commercial real estate fundraising will be interesting to watch in 2016. We are already seeing “blind pool” funds being raised through the crowdfunding platforms that enable individual investors to invest in non-traded REITs or other fund vehicles. These funds can deploy capital for real estate loans, equity investments with local sponsors, or direct investments in portfolios or even single asset properties.

How, and howmuch, Regulation A+

will be used for commercial real

estate fundraising will be interesting to watch in 2016.


Operations

In 2015, the major themes in operations centered on the heightened compliance and transparency expectations set into motion by 2014’s legislative changes, which focused on controlling risk in the fi nancial system. As it turned out, the industry absorbed those requirements fairly easily, often with the help of third-party providers who had previously geared up to meet the need. In 2016, the major operations themes will revolve around information technology—how to harness information for decision making and how to protect information in an increasingly connected (and thereby increasingly vulnerable) world.

AnalyticsOne measure of the extent of the digital transformation that is taking place across


Opportunity

the economy is that it has now begun to impact the commercial real estate sector. Historically, the industry has viewed technology like it views maintenance or employee benefi ts—an unavoidable cost but hardly something that is likely to increase profi ts or be a point of differentiation. And there were good reasons for this skepticism. This view, however, is rapidly changing for two reasons. First, there now exist analytic tools that provide value to the investor, developer, or property manager whose success depends on the quality of his or her decision making. Secondly, the industry is undergoing a generational shift in leadership as millennials—for whom technology is as fundamental as indoor plumbing—rise up in the ranks of commercial real estate industry leadership and begin to exert infl uence.


Firms that are beginning to see technology as an investment rather than an expense are also discovering that the key to success is in managing the integration—not just in terms of the technology but more importantly, the culture of the fi rm. At fi rst, the new-fangled platform will seem a poor substitute for Excel, but that is only because the learning curve has yet to be scaled. But as the fi rm’s early adopters show what can be done, others will follow their lead.

But this is just the start. Technology is not an end to itself. As fi rms begin to broadly adopt analytical platforms, they will begin to differentiate themselves based on how well they leverage these new tools. Here’s what we expect to see from the most forward-thinking fi rms:

• Creating a culture in which data analytics supports the deal makers and property managers on the front lines and gives them information in forms they can use to make more informed decisions.

• Reaching outside the industry and hiring graduates coming out of the growing number of data analytics programs. Far from being a detriment, their lack of real estate industry experience means they will bring a fresh perspective to what can be done with the piles of information at their disposal.

• Using data to look more broadly at the world and real estate’s place in it. Real estate opportunities rise and fall with changes in demographics, employment, health care, and many other factors that can be quantifi ed. Data analytics gives a fi rm the ability to take that analysis in-house and make it part of its strategic planning.

In the same vein, we expect fi rms to harness data to look for new ways to add value to their tenants—and their tenants’ customers—by enhancing the experience of the end user whether that is the retail shopper or the millennial apartment dweller.

In property management, the rise of the Internet of Things—increased interconnectedness between different systems such as HVAC, vertical transportation, and other systems—will enable increasingly sophisticated management of facilities. Algorithms analyze traffi c patterns, temperature, and other variables in real time to maximize comfort and reduce cost.

Like executives in most industries,

decision makers in commercial real estate are concerned about

cybersecurity. However, ... relatively few fi rms have been able to

translate that concern into action.


Cybersecurity

Like executives in most industries, decision makers in commercial real estate are concerned about cybersecurity. However, our observation has been that relatively few fi rms have been able to translate that concern into action. There are two good reasons for this. First, commercial real estate is a largely unregulated industry. Unlike public companies, healthcare fi rms, and fi nancial services enterprises, for example, there is no compliance regime equivalent to Sarbanes-Oxley, HIPAA, or FINRA to guide the industry’s cybersecurity efforts. Each fi rm is essentially on its own in determining what constitutes substantive risk and an adequate response.

Second, in the deal-focused world of commercial real estate, IT, like many other back-offi ce functions, has been historically considered a cost center, tangential to the fi rm’s core mission, and thus kept on a tight budgetary leash. This means that taking a more proactive stance on cybersecurity requires a change in the way IT has been regarded. But so far, when real estate fi rms have been victims of cyberattacks—such as “spoofi ng” emails that appear to be from a legitimate source requesting a transfer of funds—those issues are usually dealt with quietly. There has yet to be a Sony, Home Depot, or Target-caliber wake-up call that would spur the real estate fi rms and the funds (including high net worth individuals that invest in them) to take a more aggressive stance toward cybersecurity.

In our view, 2016 needs to be the year that the commercial real estate industry compels itself to make cybersecurity a strategic priority—before disaster strikes. The reason has to do with the changing IT profi le of the industry. As the Internet

of Things continues to move from whiteboard to reality, the vulnerable “attack space” of the industry becomes both larger and more tempting to the cyber underworld. Consider, for example, the economic consequences of having the “smart” elevators in a class A offi ce building shut down as part of an extortion attempt. This is the not-so-distant future for which commercial real estate IT departments must prepare.

There is a tendency in most organizations, regardless of sector, to think of cybersecurity as an IT issue. But true cybersecurity involves the enterprise at multiple levels, and attention must be paid to each. This is one reason that implementing an effective cybersecurity program requires a visible commitment from the head of the fi rm.

The commercial real estate industry is centered on the savvy evaluation of risk. In other words, the necessary perspective for best practice cybersecurity is already baked into the industry. Firms need merely to understand that IT is no longer ancillary to their business, but central to it, and then apply the corresponding level of care.

True cybersecurity reaches from the

boardroom tothe back offi ce.


Market Sectors

As in 2015, the overarching dynamic for 2016 continues to be a great deal of capital chasing too few deals. Developers and fund managers are reacting in a number of ways. Managing the expectations of investors eager to put capital to work is key. Some funds are asking investors to rethink the limitations they put on the types of deals they will invest in. But counseling patience merely buys time. Funds and developers are also having to become more entrepreneurial, mining opportunity in markets that would have been passed over only a couple of years ago.

Consider, for example, the plight of the suburb. Only a few years ago, the suburbs were largely regarded as a forlorn collection of 1980s offi ce parks without much future at a time when the Central Business District (CBD) has taken center stage. The allure of the CBD has indeed continued—so much so that millennials are being priced out of the trend they helped to

bring about. Developers quickly realized that those old offi ce parks offered the basic footprint that could readily be converted into 18-hour live/work/play hubs that could offer an affordable alternative, especially if it were connected to the city by mass transit.

Other developers and funds are going so far as to redefi ne what is meant by “real estate investment,” buying portfolios of cell phone towers or outdoor advertising space. While it’s too early to say how those “markets” will fare, the larger point as we head into 2016 is clear. Real estate investors and developers would be well-served to look at the larger set of skills and resources that they have at their disposal. Their access to capital. The ability to analyze deals. Their knowledge of local markets. Of course, the caveat to stick to what you know still applies. But seen from this larger perspective, a portfolio of cell phone towers doesn’t seem so far-fetched.


Opportunity


Multifamily2015 was the year in which people got tired of talking about the imminent collapse of the multifamily bubble and started to accept the fact that the sector continues to benefit from fundamental shifts in demographics, home ownership, economic improvement, and a seemingly endless supply of capital. Millennials are putting off starting families, and when they do, are choosing to sacrifice space for location. They are willing to live in smaller quarters in urban areas rather than move to the suburbs. (As noted elsewhere, suburbs are making a comeback—but largely to the extent to which they can mimic on a smaller scale the pulse of an urban center.) Younger millennials are foregoing space from the start, fueling a trend in micro apartments of 350 square feet or less.

It is tempting to attribute these developments to the fact that millennials came of age against the backdrop of the housing bubble. While that has certainly been a factor, we are also seeing two deeper forces at work. Embracing smaller living spaces allows millennials to live where they want to live—a strong manifestation of the growing inclination to value experience more than material objects. Second, millennials are “digital natives,” and the fact is that a digital life—one in which all photos, music, and books are online, for example—simply requires less space. We don’t expect either of these trends to reverse themselves any time soon. So it is that the Harvard University study “State of the Nation’s Housing 2015” predicts a future in which 60% of adults are renters, turning the traditional post-World War II home owning metric on its head.

In other words, the 5.4% increase in renewal rates and 5.9% increase in effective rents witnessed in the third quarter of 2015 are the numbers we would expect from an asset class in transition. While some absorption in some markets is leveling off, nationally we are far from capacity despite record completions. As a result, multifamily is not only the most successful asset class among commercial real estate sectors, it has arguably become the single most significant driver in the growth and improved success of other sectors such as retail and self-storage.

Not surprisingly, this asset class has increasingly become a favorite of institutional investors, private equity funds, and REITs.

OfficeLast year was a strong one for the office sector, and 2016 should bring more of the same. This asset class continues to be a favorite of institutional investors who continue to expand their sights into secondary markets. In our view, there are two main reasons why office fundamentals continue to be strong. First, despite the rise of freelance workers and the “gig economy,” office-based jobs are still accounting for 39 percent of total job growth—as long as the economy continues to expand, and the employment picture improves, the need for office space will increase as well.

The second reason why the sector will continue to be attractive is far less cyclical. How people work, and the spaces they need to work most effectively, continues to fundamentally change. This has brought about both the need and the opportunity for significant amounts of adaptive reuse. Consider the following trends:

• Cubicle-intensive tenants like law firms and accounting firms are giving way to software companies and app-based services that favor open areas, ergonomic lighting, and tech-intensive infrastructure. The trend toward “densification” is another trend making old floor plans obsolete.

• Employee expectations regarding amenities have carried over from multifamily living. Along with the usual operations contingent, companies looking to rent space now bring along the human resources director to see if the new office has sufficient common areas, recreational facilities, green design, and other details.

• With the rise of ride sharing, better public transportation, and the inclination of people to live where they work, parking lots no longer require the space they once did, presenting developers with an interesting reuse challenge and opportunity.


As we look to 2016 and beyond, there are two specialty trends we will be keeping our eye on. One is the rise of co-working spaces, perhaps the ultimate “densifi cation” reuse strategy. Does the rapid growth of this subsector signal a real, permanent shift in how we work, or will it fade over time? The second is the suburban medical campus, which represents a confl uence of changes in healthcare, demographics, and market opportunity. As healthcare delivery shifts from independent physicians to hospital systems, and as baby boomers continue to age and live longer, hospital systems are setting up satellite facilities in offi ce parks—another factor contributing to the rebound of the suburbs noted above.

RetailAs the multifamily sector responds to changes in how people live while offi ce properties are reconfi guring to match developments in the workplace, activity in the retail sector is being driven by the ongoing evolution from shopping to “the shopping experience.” Online shopping, it turns out, did not kill bricks and mortar retail, but rather reoriented it. Yes, people can buy whatever they want online, but it turns out—as retailers themselves have long known—that mere purchasing is not enough. For most of history, after all, shopping has been a physical, tactile and, ultimately, social activity.

In 2016 and beyond, retail will continue to reclaim this heritage in the form of exciting, vibrant six or eight block unifi ed environments of pedestrian friendly storefront retail mixed with restaurants, cafes, theaters, and hotels. These environments will include upscale

apartments centered around fountains, public squares, and other areas for public interaction. The hunger for this type of retail complex is particularly acute in fast-growing, car-centric cities such as Los Angeles, Houston, and Atlanta—cities with high population density that lack the public spaces that older cities do.

Savvy developers will see this need as an opportunity to not just build properties but to create deeper partnerships with their retail tenants. Indeed, developers looking to harness data to improve operations will fi nd that much can be learned from the retail sector—a relatively early adopter of data analysis to manage inventory and spot consumer trends. Working together, developers and retailers have the opportunity to make the retail experience even more responsive and innovative. In fact, this unifi ed concept of multifamily and retail will also prove to be a strong driver for shifts in investment strategies toward suburban markets.

IndustrialThe industrial sector, which had experienced a long period of relative dormancy, has in the last few years gained considerable traction largely powered by the need for reconfi gured distribution infrastructure to meet the exploding demands of e-commerce. While this trend continues—and should through 2016—one additional development we have seen in our clients is notable activity in self-storage. Some investors have long been attracted to this specialty asset class, which tends to produce attractive revenue streams—and without tenants. But activity has experienced a notable uptick since the Great Recession of 2007-2009, as people downsized their living spaces and needed storage space for excess belongings. Indeed, the activity in this sector has fueled consolidation as investors seek market dominance through acquisition of less-deep-pocketed rivals.

It will be interesting to see the long-term trajectory of the self-storage category. If we are truly entering a digital era centered on experience and information rather than objects, self-storage centers may become even more important as a way station for an increasing number of things we no longer need but are not yet ready to live without.

Online shopping, it turns out, did not kill

bricks and mortar retail, but rather reoriented it. Yes, people can buy whatever

they want online, but it turns out ... that mere

purchasing is not enough.


For our owner/operator clients,

optimizing operations is the focus. Data analytics

has become even more central to the process

than it has been in the past.

HotelsThe hotel sector continues to expand to meet the demand for increased capacity. This expansion comes in the wake of the tremendous contraction the sector underwent during 2007-2009. In fact, we don’t expect supply to catch up to demand until 2019 or 2020. In pragmatic terms, this means that those looking toward a deal should do so now, while there is still a considerable tailwind to harness.

For our owner/operator clients, optimizing operations is the focus. Data analytics has become even more central to the process than it has been in the past. The hotel asset class, because it is built on selling property with a one-day term, has always been more data-centric than most of the other real estate sectors. But even so, managers are working double time to absorb and synthesize the amount of data that is now available.

Online reputation management is another critical area. Even with supply behind demand and steady increases in Average Daily Rates, travelers are ruthless in summarily rejecting properties with even one or two bad reviews. It is essential for operators to invest in the resources to monitor and respond to social media and travel sites in real time.

As with offi ce and multifamily, there is a greater sensitivity to amenities in the hotel sector than there has been in the past. But here we caution restraint. Investing in elective amenities (that is, those not dictated by the franchisor) should be done in the context of a larger business strategy—to attract a certain type of traveler or to differentiate yourself in the market in some way. It is too easy to get caught in an endless cycle of “keeping up with the Joneses” that brings no signifi cant return on investment.

The fl ip side of this is to fully leverage an amenity that can truly differentiate the property. This strategy can be particularly powerful for properties located in historic districts. One client bought a hotel property that had a reputation for being haunted. The new owner promptly set up “haunted tours” that have become both a source of distinction and a continual revenue stream.


In our view, the “rational optimism” that defi ned the commercial real estate market in 2015 has every reason to continue through 2016. The breadth and extent of the industry’s trajectory reinforces the conclusion that much of the industry’s activity is driven by the race to meet a wide range of societal needs: Millennials need smaller, more ergonomically designed and more affordable apartments in vibrant areas. Companies need offi ce space attuned to an increasingly wired, mobile, and autonomous workforce. E-commerce giants need the warehousing and distribution capabilities that can continue to scale to their growth.

These needs are much stronger now than they were before the recession—if they even existed then at all. It falls to the commercial real estate industry to effect these changes for a vast country. As long as the industry continues to exercise discipline and judgment, it will continue to benefi t from these opportunities.

Conclusion


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.

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.

For more information, visit www.cohnreznick.com.

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www.cohnreznick.comCohnReznick is an independent member of Nexia International

CohnReznick LLP © 2016Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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