First Half 2011

MEDICAL OFFICE SECTOR IMPROVES AS JOB GROWTH,DEMOGRAPHICS DRIVE HEALTHCARE DEMAND

Medical offi ce performance will gain momentum in 2011 as improving employment, increased healthcare spending and the aging population strengthen demand, despite challenges to healthcare reform. Healthcare spending is projected to rise by $76 billion over the next two years as job growth returns coverage to more individuals and people undertake elective procedures postponed during the recession. Steady demand will drive healthcare employers to hire 380,000 workers in 2011, expanding head counts in the sector by 2.3 percent, outpacing total employment growth of 1.5 percent . The Patient Protection and Affordable Care Act (PPACA) will further support demand for healthcare services. While most of the bill does not take effect for another three years, the part to extend coverage to persons under the age of 27 via their parents’ plans was enacted in September 2010. With approximately 30 percent of young adults aged 19 to 29 without insurance, the highest rate among all age groups, the recent expansion will boost near-term demand. Refl ecting these positive trends, medical offi ce vacancy will fall 60 basis points this year to 11.2 percent as below-average construction accelerates absorption. Improving occupancy will spark asking rent growth for the fi rst time since 2008, led by gains in the Northeast and Texas; both areas will register asking rent increases averaging between 1.5 percent and 2.0 percent.

Medical offi ce operations will likely improve further over the long term as the aging of baby boomers supports the need for healthcare services. The number of Americans over age 65, the population segment with the greatest healthcare needs, will expand by a considerable 36 percent over the next 10 years. This shift in demographics will necessitate additional healthcare staff and medical offi ce space, as individuals in this age bracket require almost double the number of visits per person than any other group. Should the PPACA survive the legal challenges ahead, the long-term impact will accelerate this growth in demand. The current legislation will bring coverage to as many as 32 million previously uninsured individuals, requiring another 62 million square feet of medical offi ce facilities by 2014.

Investor demand for medical offi ce assets will accelerate in 2011, driven by renewed interest in growth markets in the Southeast and Southwest/Mountain regions . Medical offi ce operations rebounded early in the recovery cycle, spurring an increase in investment activity in 2010. Texas registered the most signifi cant improvement, with more than twice as many properties trading last year as in 2009, though sales activity in the Midwest, which excludes the Texas markets, dipped 20 percent. The Southeast and Southwest/Mountain regions recorded the sharpest declines in investment activity through the downturn, but resumed hiring and population growth this year will improve medical offi ce vacancy rates, subsequently luring buyers from the sidelines. As investors begin to include mid-tier properties in their strategies this year, cap rates nationwide will decrease for the fi rst time since 2007 . Moreover, despite lingering uncertainties over healthcare reform, demand for medi-cal offi ce properties will remain strong, as demographic changes and rising healthcare spending support the growing need for healthcare space, even without the new legislation.

Year

-ove

r-Ye

ar C

hang

e

Employment Trends

-6%

-3%

0%

3%

6%

11*090705030198979593

Total EmploymentHealthcare Employment

* ForecastSources: Marcus & Millichap Research Services, BLS, Economy.com

Tota

l Pop

ulat

ion

(mill

ions

)

Total Population Age 65+

20

30

40

50

60

20*15*10050095908580* ForecastSources: Marcus & Millichap Research Services, U.S. Census Bureau

Num

ber

of V

isit

s pe

r Pe

rson

Annual Physician Office Visits per Person

0

2

4

6

8

Age 65+Age 45-64Under Age 45* ForecastSources: Marcus & Millichap Research Services,U.S. Department of Health and Human Services

Squa

re F

eet

(mill

ions

)

Medical Office Construction by Region

0

0.6

1.2

1.8

2.4

CA/PacificNW

SW/Mountain

TexasMidwestSENE

2009 2010 2011*

* ForecastSources: Marcus & Millichap Research Services, CoStar Group, Inc.

Ave

rage

Vac

ancy

Rat

e

Medical Office Vacancy by Region

6%

9%

12%

15%

18%

CA/PacificNW

SW/Mountain

TexasMidwestSENE

2010 2011*

* ForecastSources: Marcus & Millichap Research Services, CoStar Group, Inc.

NATIONAL TRENDS◆ Construction Trends: During 2010, medical offi ce property completions to-

taled 4.7 million square feet, less than half the amount delivered in the previous year and down from 17.2 million square feet at the cyclical peak in 2008. Un-like traditional offi ce properties, where new construction will remain limited in 2011, development of medical offi ce buildings will increase due to consistently strong tenant demand. This year, developers will deliver 7.9 million square feet.

◆ Rent/Vacancy Trends: Growing demand for healthcare services and a 52 per-cent drop in completions last year helped medical offi ce occupancies bounce back early in the recovery cycle. Vacancy decreased 50 basis points in 2010 to 11.8 percent and will continue to trend down this year, sliding 60 basis points to 11.2 percent on positive net absorption of 10 million square feet. Despite gains in the Northeast, medical offi ce asking rents nationwide dropped 1.4 percent last year. The Southeast region posted the largest rent cut at 5 percent, while rents in Texas decreased by less than 1 percent. During 2011, U.S. asking rents will tick up 0.9 percent, with the Northeast and Texas leading the way.

◆ Investment Trends: Investment activity involving medical offi ce assets in-creased 26 percent last year, after falling 54 percent through the recession. As public REITs and institutional investors re-emerged, total dollar volume rose 38 percent. Prices in the segment have been less volatile than in other property types due to stronger investor demand and healthier operational performance. The median price among medical offi ce assets traded in 2010 stabilized at $166 per square foot, while cap rates rose just 20 basis points to the high-7 percent to low-8 percent range.

SOUTHEAST◆ Construction Trends: Developers completed 637,000 square feet of new

medical offi ce space in the Southeast region last year, down from 1.9 million square feet in 2009 and 4.1 million square feet at the cyclical peak in 2007. This year, nearly 1.2 million square feet will come online, with Atlanta and Charlotte receiving over half of the new space.

◆ Rent/Vacancy Trends: Following a 160 basis point spike in the previous year, vacancy in the Southeast fl attened at 12.8 percent during 2010. Rates vary signifi cantly by metro, however, with the vacancy rate in supply-constrained markets such as those in South Florida averaging close to 10 percent. In metros where development is less challenging, including Atlan-ta and Orlando, vacancy averages in the high-teens. Regionwide, vacancy will slip 30 basis points this year to 12.5 percent as demand for medical services grows. After falling 5 percent in 2010, asking rents will remain es-sentially fl at this year at $21.45 per square foot.

◆ Investment Trends: Transaction velocity in the Southeast decreased 7 per-cent last year, as elevated vacancy rates and sliding rents maintained in-vestor caution. Buyers continued to underwrite for declining NOIs, raising average cap rates by 60 basis points into the low- to mid-8 percent range, while the median price fell 12 percent to $150 per square foot. More inves-tors will return to the region this year as medical offi ce vacancy rates start to improve and strong employment gains signal a sustainable recovery.

page 2 Marcus & Millichap ◆ Medical Offi ce Research Report

Regional defi nitions are available on page 4.

Year

-ove

r-Ye

ar C

hang

e

Medical Office Asking Rents by Region

-6%

-3%

0%

3%

6%

CA/PacificNW

SW/Mountain

TexasMidwestSENE

2010 2011*

* ForecastSources: Marcus & Millichap Research Services, CoStar Group, Inc.

Ave

rage

Cap

Rat

e

Medical Office Cap Rates by Region

6%

7%

8%

9%

10%

CA/PacificNW

SW/Mountain

TexasMidwestSENE

2008 2009 2010

* ForecastSources: Marcus & Millichap Research Services, CoStar Group, Inc.

Medical Office Sales TrendsMedian Price per Square FootAverage Cap Rate

$125

$150

$175

$200

$225

05 06 07 08 09 105%

6%

7%

8%

9%

Med

ian

Pric

e pe

r Sq

uare

Foo

t

Average Cap Rate

* ForecastSources: Marcus & Millichap Research Services, CoStar Group, Inc.

NORTHEAST◆ Construction Trends: Medical offi ce property deliveries in the Northeast

slowed considerably in 2010, as only 311,000 square feet of new space came online, down from 1.7 million square feet in the previous year. During 2011, developers will complete 1.4 million square feet, with deliveries in Boston and Philadelphia accounting for the largest share.

◆ Rent/Vacancy Trends: Medical offi ce vacancy rose just 10 basis points last year to 10.1 percent due to resumed job growth in the region. This year, vacancy rates will fall 40 basis points to 9.7 percent on positive net absorp-tion of 1.9 million square feet. Rents advanced 3.7 percent in 2010, surging on the delivery of a few new builds in the fourth quarter . Rent gains will moderate in 2011, with the average rate increasing 1.9 percent to $24.90 per square foot.

◆ Investment Trends: Sales velocity remained relatively even last year, after plummeting 51 percent in 2009. Investors continued to underwrite for fall-ing NOIs, though, pushing cap rates slightly higher into the mid- to high-7 percent range. A strong rebound in hiring and constraints on new supply will attract investors seeking stabilized assets in the region.

TEXAS◆ Construction Trends: Developers completed 1.8 million square feet in Tex-

as last year, roughly half the fi ve-year average. In 2011, deliveries will ac-celerate to 2.1 million square feet, expanding inventory 3.1 percent.

◆ Rent/Vacancy Trends: Despite the uptick in medical offi ce completions this year, growing space demand will result in positive net absorption of 2.1 million square feet, pulling down vacancy rates 50 basis points to 12.7 percent. Asking rents will rise 1.5 percent to $22.63 per square foot, after slipping 0.3 percent last year.

◆ Investment Trends: Sales velocity in Texas increased 60 percent in 2010 as the capital markets began to ease and property operations stabilized . The median price dropped 16 percent during that time to $198 per square foot, while cap rates averaged in the high-8 percent range. Investor interest will remain strong in Texas, as employment and population growth rates above the national average point to increased need for medical services and space.

SOUTHWEST/MOUNTAIN◆ Construction Trends: Medical offi ce completions in the Southwest/Moun-

tain region will total 819,000 square feet in 2011, roughly double deliveries in 2010 but far below the fi ve-year average of 3 million square feet.

◆ Rent/Vacancy Trends: The slowdown in construction this year, coupled with increased insurance coverage, will cause vacancy to fall 70 basis points to 14.6 percent, after slipping 50 basis points in 2010. Despite accelerating absorption, asking rent growth will remain modest due to still-elevated va-cancy rates. During 2011, asking rents will increase just 0.8 percent to $21.93 per square foot, following a 2.6 percent drop last year.

◆ Investment Trends: Property sales rose 41 percent in 2010 as buyers took advantage of distressed listings and improving operations eased concerns of further NOI deterioration. The median price remained at $161 per square foot, while cap rates averaged in the mid- to high-8 percent range. Increased activity will push prices higher this year as favorable demographics draw long-term hold investors back to the region.

Marcus & Millichap ◆ Medical Offi ce Research Report page 3

Regional defi nitions are available on page 4.

CALIFORNIA/PACIFIC NORTHWEST◆ Construction Trends: Last year, 884,000 square feet of medical offi ce proj-

ects came online in the California/Pacifi c Northwest region, with the bulk of the new space added in Sacramento, Los Angeles and Orange County. In 2011, construction output will swell to 1 million square feet.

◆ Rent/Vacancy Trends: A sharp slowdown in construction contributed to vacancy falling 30 basis points in 2010 to 9.1 percent, the lowest rate among major U.S. regions. Still, rents declined 3.5 percent to $26.70 per square foot as the market continued to correct from the sharp run-up prior to the reces-sion. Rents will remain fl at through the fi rst half of 2011 and tick up in the second half. Vacancy will retreat 50 basis points for the year to 8.6 percent.

◆ Investment Trends: Deal fl ow increased 10 percent last year, but a larger proportion of distressed sales compared to 2009 pulled down the median price 6 percent to $210 per square foot. Cap rates compressed in 2010, av-eraging in the mid-7 percent range for most assets, though yields can reach the mid-8 percent range in metros with higher levels of distress, including the Inland Empire, Los Angeles and Sacramento. Assets in coastal areas will continue to draw investor interest due to their low vacancy rates and high development costs, but these rarely available properties typically com-mand elevated prices.

MIDWEST◆ Construction Trends: While commercial real estate construction has virtu-

ally stalled throughout most of the Midwest, builders continue to deliver medical offi ce properties. Approximately 1.4 million square feet will come online in the region this year, following the addition of 1 million square feet in 2010. Chicago will receive roughly half of the deliveries, but inventory levels will increase in even the region’s hardest-hit metros, including De-troit and Cleveland.

◆ Rent/Vacancy Trends: Vacancy slipped 20 basis points in 2010, although robust construction will limit improvements this year. Vacancy will fall just 10 basis points during 2011 on positive net absorption of 1.4 million square feet. Rents will drop 1.1 percent to $19.00 per square foot, despite modest gains in the second half.

◆ Investment Trends: Sales of medical offi ce properties slowed by 20 percent last year, as investors remained cautious about the region’s economic recov-ery. The median price dropped 18 percent to $95 per square foot, and cap rates averaged in the mid- to high-8 percent range, up 30 basis points from 2009 . Price declines and cap rate increases, however, have yet to stimulate signifi cant investor demand in most Midwestern markets. As such, buyers will continue to target low-vacancy, premium assets in higher-population-growth metros, including Indianapolis and Columbus, until signs of a sta-bilized recovery emerge.

Marcus & Millichap’s Healthcare Real Estate Group is comprised of real estate investment professionals who specialize in healthcare properties nationwide. In addition to offering specialized market knowl-edge, members of the Healthcare Real Estate Group are able to the leverage the fi rm’s network of more than 1,300 investment professionals to help clients meet their investment objectives.

For information on Marcus & Millichap’s Healthcare Real Estate Group, contact:Alan PontiusManaging DirectorTel: (415) 963-3000apontius@marcusmillichap.com

For information on national offi ce trends, contact

John ChangVice President, Research Services

Tel: (602) 678-6700 ext. 6803john.chang@marcusmillichap.com

© Marcus & Millichap 2011www.MarcusMillichap.com

Regional Defi nitions:California/Pacifi c Northwest: Los Angeles, Oakland, Orange County, Portland, Riverside-San Bernardino, Sacramento, San Diego, San Francisco, San Jose, Seattle-TacomaMidwest: Chicago, Cincinnati, Cleveland, Columbus, Detroit, Indianapolis, Milwaukee, Minneapolis, St. LouisNortheast: Boston, New York City, Northern New Jersey, Philadelphia, Washington, D.C.Southeast: Atlanta, Charlotte, Orlando, South Florida, TampaSouthwest/Mountain: Denver, Las Vegas, Phoenix, Salt Lake City, TucsonTexas: Austin, Dallas/Fort Worth, Houston, San Antonio

The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research Services, Bureau of Labor Statistics, CoStar Group, Inc., Economy.com, TWR/Dodge Pipeline, U.S. Census Bureau.