These trends reflect a more cautious outlook on behalf ofprivate investors who in recent quarters have become concernedabout the degree of price appreciation over the past few years,historically low cap rates and the prospects of a slowing economy.On the other hand, institutional investors, which have structurallyshifted toward raising their real estate allocations, areconcentrating their acquisition activity on larger, top-tierproperties in primary markets. Another factor behind the increasein larger property sales is the privatization of large (major)REITs, mergers and the spin-off sales that have followed them.Lastly, larger private investors who have built up significantequity over the past few years are consolidating their equity outof multiple, smaller properties, to larger, more institutionalproperties. Many of these private investors are baby boomers whoare getting closer to retirement and their priority is shiftingtoward wealth preservation and income.

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The common theme throughout the majority of the marketplace isstrength in valuation. While the rate of appreciation for smallerproperties has slowed significantly, pricing pressures and cap ratecompression are common for top-tier assets. Class B and Cproperties are experiencing more of a pricing gap and have seen amoderate increase in cap rates as a result, particularly insecondary and tertiary markets. Improving property fundamentals inmost sectors, balanced new construction and healthy rent growth aresupporting values and will continue to do so. As prices stabilizeand net operating incomes improve over the next 12 to 24 months,cap rates will move up moderately but are unlikely to return totheir long-term averages in the foreseeable future, since there isno cause for deep discounting of real estate prices.

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In a low-yield environment, investors are clearly shiftingtoward emerging property types and value-add opportunities. This isleading many investors to seek opportunities in the office andindustrial sectors. Although the bulk of recovery in office marketfundamentals is in the past, the sector continues to offercomparatively strong potential for near-term revenue growth throughrent increases and further cutbacks in concessions. Cap rates foroffice properties continued to decline in early 2007 but areexpected to level off as the year progresses. Major coastalmarkets, such as New York, Los Angeles and San Francisco, couldprove to be the exception. Despite rapid price appreciation inrecent years, office property replacement costs in these marketsare still estimated to be 35% to 45% greater than sales prices, andrapid rent growth has been recorded so far this year. While theoutlook for the office market remains optimistic, investors wouldbe wise to keep a close watch on the development pipeline. Inmarkets that registered the greatest declines in homebuildingactivity, a downward correction in land prices andlabor/construction costs could prompt commercial developers tocommence new projects in the near term.

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Apartment fundamentals began to show signs of softening latelast year, attributable in large part to the growing shadow-rentalmarket. While the market recorded another uptick in vacancy in thefirst quarter of 2007, the increase was modest and typical for theearly months of the year. There is, however, little doubt that theoversupplied condo market will lead to rising vacancy in a handfulof markets as 2007 progresses, but long-term renter-demand driversremain firmly in place. Cap rates for true value-add properties andluxury apartments dipped slightly during the early part of the yearas prices continued to rise, though cap rates for smaller,lower-quality assets have moved upward. While competition forbest-of-class assets is expected to remain at high levels, smaller,private buyers are more selective and expecting higher returns tocompensate for the perceived increase in risk created by economicuncertainty. Overall, given the depth of apartment demand and theavailability of capital in the market, however, a major movement incap rates is not in the cards.

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Turmoil in the residential subprime mortgage market is adouble-edged sword for the commercial real estate market. On onehand, foreclosure activity is expected to impact consumer spending,which has been a key driver of economic growth and the retailmarket's stability in recent years. Retail development has beenbased primarily on tenant demand, but slower spending is likely toresult in moderate increases in retail vacancy this year.Competition for top-tier retail properties is expected to remainelevated throughout 2007 as major retail investors continue toupgrade their portfolios. The limited availability of large,high-quality retail properties has actually driven many largeowners to development. Strip center properties and lower-quality,single-tenant assets, however, are facing more scrutiny in today'smarket, which is likely to result in slight increases in cap rates.During the early months of 2007, for-sale retail inventory of stripcenters increased significantly, which combined with a morediscerning buyer pool could result in more upward pressure on caprates by year's end.

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The flipside of the unraveling subprime mortgage market is thattighter lending restrictions are expected to prohibit many would-behomebuyers from purchasing homes over the next few years, whichbodes well for apartment owners. Mortgage foreclosures are alsorising, which will also result in a growing number of formerhomeowners returning to the rental market.

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While there are certainly factors that commercial real estateinvestors should monitor closely this year, the overall outlookremains very positive. Interest rates are still low by historicalstandards, and there is more capital available in the market todaythan ever before. Long-term interest rates have proven to be highlysusceptible to rapid fluctuation in recent months, as the bondmarket's reaction to economic indicators and foreign fund flows hasbeen swift. However, the economic slowdown and increased riskfactor due to the housing cycle point to flat or lower interestrates, as opposed to any major factor driving interest ratessubstantially higher. Investors who wait on the sidelines this yearfor a major correction in prices, or those who do not take the timetoday to evaluate current holdings based on return on equity, standthe greatest chances of missing out on significant opportunity.

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Harvey E.Green is the president and CEO of Encino, CA-based Marcus& Millichap Real Estate Investment Services. The viewsexpressed in this article are the author's own.

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