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2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

2009 economic outlook & market fundamentals nd

2 quarter update July 2009

Copyright © 2009 by Morguard Investments Limited, a Wholly Owned Subsidiary of Morguard Corporation. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base retrieval system, without the prior written consent of Morguard Investments Limited, 55 City Centre Drive, Suite 800, Mississauga, Ontario, L5B 1M3. Any request for photocopying, recording, or taping of any part of this publication shall be directed in writing to Morguard Investments Limited: Manager of Research.

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

2009 economic outlook & market fundamentals 2nd quarter update Table Of Contents:



Financial Report



Investment Report



Leasing Report



Economic Report



Transactions

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Acknowledgements/Works Cited

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

Real estate provides a significant contribution to the performance of an investment portfolio, and hence is a consistently preferred asset class in the investment community. The following quarterly report provides an updated commentary on: investment trends, economic data, financial conditions and leasing fundamentals that affect the performance, attractiveness, associated risks, and outlook for the real estate investment market.

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

Financial Report SUMMARY By the mid-point of this year financial markets had begun to emerge from the crisis of late 2008, as credit conditions eased and wholesale funding markets became less strained. As global responses to the worst financial crisis since the early 1930’s gained traction, credit markets have started to loosen. Near term funds became more readily accessible and longterm credit opened up for investment grade and some high-yield issuers, according to the latest Financial System Review of the Bank of Canada released in June. These trends indicate investors are beginning to reduce their aversion to risk, thereby offering hope for global economic stabilization. Indeed, the continued stabilization of global financial systems will key global economic recovery. Capital markets have also started to show signs of life, perhaps as a precursor to a full-blown economic recovery. Equities markets have seen values climb from cycle lows. Short-term funding has also improved year-to-date, with gradual declines in the spread between the three-month Libor rate and the overnight index swaps, driven mostly by central bank fund injections into the global financial system. Concerns over global financial systems failure has lessened, as a result of a myriad of debt guarantees, capital injections and the renewed commitment by G-20 nations to ensure “systematically important” institutions remain afloat. The stabilization of capital markets bodes well for Canada’s financial system, which is directly impacted by the health of its international counterparts. Expanded Bank of Canada liquidity facilities and the Canadian Government’s purchase of insured mortgages with assistance from the CMHC continues to provide greater access to longer-term financing for Canadian institutions. Improved access to these funds has reduced spreads on money market financing, provided a modest extension of maturities and decreased costs of term funding. In addition, Canadian banks have been able to increase government security holdings in order to enhance their cash positions. Strong retail deposits and lower demand for credit have also positioned Canadian banks to withstand further global economic strife. Looking ahead continued improvement in the Canadian financial system will depend on the successful management of both individual financial institutions and systems globally, in order to enhance continued economic stabilization.

FORECAST Canada’s financial markets are forecast to gradually improve over the balance of 2009, although significant risk of further economic sluggishness will persist. While spreads between bank funding and government yields should continue to narrow, a deeper economic contraction could dilute earnings and result in more loan losses and a weakening of the Canadian financial system overall. Domestic banks, in an effort to support capital ratios, may be forced to reduce lending causing tighter conditions once again. Countries often adopt protectionist measures to counteract changes in currency values, which materially impact trade and credit flows, which along with changes in asset pricing would result in additional risk for continued recovery. In summary, Canada’s financial system has improved substantially thus far in 2009, however sufficient risk exists that could derail further stabilization. These are rooted in the vulnerability of global economic recovery, the effectiveness of government responses and consumer confidence.

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

Investment Report SUMMARY Sales of income producing commercial real estate are well below their record-setting peak volumes prior to the credit crunch, as a result of limited access to debt financing and the gap between vendor and purchaser pricing expectations. Although demand for income producing real estate remains strong, limited access to debt financing, particularly for offerings of over $20 million, resulted in sharply reduced transaction volume. Vendors in turn have become wary of bids that are conditional on financing, without assurance that the funds are available, in some instances choosing a lower bid with a higher probability of closing. Increasingly VTB financing has been used to assist purchasers in meeting equity thresholds to close transactions. The recent decline in transaction volume also resulted from the reluctance of vendors to realize that values have declined from the peak. In some cases vendors have chosen to remove offerings from the market. Evidence of the slowdown in transaction closings is confirmed through an analysis of transactions completed in the Toronto, Calgary and Vancouver markets. According to RealNet Canada data, there were 58 transactions with a minimum sale price of $20 million completed in the first half of 2008. In the first half of 2009, there were 13 transactions completed, representing a 78% decline in activity year over year, a trend that is likely to continue in the near-term. Debt markets remain closed to some buyer groups while well-capitalized buyers stockpile cash. At the same time, many investors have focused on core investments, by protecting and enhancing income during economic and space market declines. Others have amassed significant capital war chests in anticipation of improved returns either in Canada or in other countries where values are expected to decline further. Returns have improved in some sale scenarios from market peaks in Canada, however not enough for some investors. Some assets have sold at reduced pricing levels from those established at the start of negotiations in late 2008. In summary, investment sales volume will remain below recent averages as vendors come to terms with declining values and continue to hold out for pre-credit crunch pricing levels and debt financing remains in relatively short supply.

FORECAST There is little evidence to suggest commercial real estate investment trends will change this year. Activity levels will remain below recent averages until values are re-established and debt-financing access improves. Financial institutions will continue to largely lend to groups with superior balance sheets, remaining reluctant to increase their exposure to the commercial real estate sector. Sourcing funds for larger transactions ($20 million and over) will continue to be a challenge. Vendors will continue struggle to accept declining values in some cases. Over the second half of 2009, ICREIM/IPD data is likely to post another modest increase in cap rates a commensurate decrease in value, a continuation of a trend that saw the first decline in capital values recorded in 14 years in the final quarter of 2008. The reluctance of vendors to realize declines in value, coupled with limited access to financing will once again ensure investment sales activity will remain muted. Institutional investors will continue to stockpile capital and await better returns in other investment sectors or markets. Further, the absence of conditions supporting significant sales of distressed assets will also ensure activity remains low. In summary, trends in the Canadian commercial real estate investment sector see little change this year.

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

Leasing Report SUMMARY Battered consumer and business confidence continues to fuel increased leasing risk in the office, industrial and retail sectors, as space market fundamentals gradually deteriorate. In the office sector, the trend of tenant expansion during the peak of the current cycle has been replaced by downsizing/rightsizing of existing tenancy and a lack of business growth. Sublease offerings year over year as of the second quarter have reached 7.8 million square feet from 4.5 million square feet a year ago, which represents an increase of 73%. As space market fundamentals in the office sector weakened through this period, national aggregate vacancy climbed almost 200 bps to 8.3%. Rising vacancy not surprisingly has had an adverse impact on rents. In several markets rents have on average leveled off at close to peak levels and exhibited some erosion in others. For example in Calgary rents have declined between 5% and 15%, as the continued addition of new supply both in the suburbs and downtown have placed further downward pressure on rents. As space market fundamentals in the office sector continue to soften, investors will be increasingly challenged to maintain income and returns. In the industrial sector, trends have mirrored those of the office sector, though to a lesser degree. The lack of business growth has resulted in sharply reduced demand for space. This will likely worsen as the impact of the automotive sector fallout is realized in the coming months. National aggregate vacancy has ratcheted up by 200 bps to 7.45 year over year as of the second quarter. It is worth noting however, that declines in demand in the industrial sector are typically muted by low development risk. The development community is able to delay construction projects, as building completions typically range from five to nine months compared to minimum of 18 months in the retail and office sectors. Rents have on average eroded modestly on aggregate year over year. As employment levels continue to decline along with consumer confidence retail sales have suffered. Retailers in increasing numbers have sought rental abatements from landlords, particularly those originating south of the border. In summary, the combination of weak consumer and business demand will reflect negatively on space market trends until confidence is restored. In the meantime investors face increasing risk of income erosion in a declining market.

FORECAST Investors will face continued leasing risk through the balance of 2009, against a backdrop of weak demand, downward pressure on rents and rising vacancy. In a recent Bank of Canada survey of the top 100 Canadian companies in April, most respondent firms anticipate slumping sales, declines in hiring intentions and expect uncertainty to remain high in 2009. Not surprisingly, demand for office space is forecast to remain weak. Vacancy is forecast to continue to rise by as much as another 100 bps. Rents will dip further below the cycle-peak, particularly in areas with significant supply risk, such as Calgary and Toronto. Increased sublease offerings will drive rents lower on direct vacancy and boost vacancy overall. The industrial sector will see rising availability rates as the automotive sector continues to unravel. Development activity will slow sharply thereby softening increases in vacancy somewhat. In the retail sector, consumers, driven by concerns with job security and debt-loads will ensure sales remain well off the peak. Retailers in turn will struggle to stay afloat in increasing numbers. In short, investors will be forced to contend with increased leasing risk as the recession continues. The precarious nature of the recovery, will undoubtedly negatively impact income and in turn returns in the near term. 4

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

Economic Report SUMMARY At the mid-point of 2009 signs of an economic cycle bottom had emerged, prompting discussions of the timing and characteristics of recovery. By the second quarter it appeared that the worst of the declines in GDP had passed, with a decline of just 0.1%. The April result was on par with most forecasts. The consensus among most economists is that further declines will be tallied in May and June of this year as a result of manufacturing losses. The speculation is that a return to GDP growth will occur in the third quarter. In addition to the slowing in GDP declines is the rise in equity market values. By May the S&P/TSX Composite Index had increased by 17.2% year to date and 39% from the market low in March. Many believe this ongoing trend is a pre-cursor to a global economic recovery. Although more recently equity markets have slid on the news that US consumers continue to thwart a strong recovery by increasingly showing a propensity to save rather than spend. A marked recovery in commodity pricing over cycle lows has also provided cause for optimism. Liquidity in Canada’s banking sector has improved, driven by strong retail deposits and growth of credit. Backed by the CMHC, the Government of Canada has purchased insured mortgages, which has increased access to long-term financing for Canadian financial institutions. A further signal of economic bottoming was shown this quarter by the US stress test administered to the country’s 19 largest banks. The result was that only 10 required a combined total of $75 billion in capital in the event of a sharper-than-expected economic nose-dive, according to the Bank of Canada’s June 2009 Financial System Review paper. In summary, there are numerous signals that the economic debacle, which began with the collapse of the global financial sector, may be nearing an end. The bond market has begun to thaw and corporate spreads tightened for investment grade paper. The question at hand is when will the recovery begin and what will it look like?

FORECAST Consensus forecasts point to a return to economic expansion in the second half of 2009, although conditions supporting recovery remain tenuous. A survey of Canada’s major financial institutions, including the Bank of Canada, indicates that the Canadian economy is forecast to contract by between 2.2% and 3% in 2009. Furthermore, a return to economic expansion should materialize in either the late third quarter of early fourth quarter. Finally, through 2010 gradual expansion will reach as high as 2.5% or as low as 1.4% on an annual basis. Indeed over the last several months there have been an abundance of data supporting an easing of labour sector bad news and a modest recovery in equities, bond markets and lending markets. The trends occurred despite a further plunge in economic conditions on a global basis in the first quarter of 2009. Looking ahead to the next six months, there is reason to believe that the recovery is in some jeopardy. Recent economic trends support a modicum of concern for economic recovery. Canada will face severe manufacturing sector headwinds due to the ravaged automotive sector in the coming months. The recovery faces the serious threat of continued de-leveraging by households and businesses, which exacerbates any recovery. Household net worth declined by 8.6% from the mid-2008 peak. In June, larger than expected job losses of 467,000 in the US, resulted in a 26-year high unemployment rate of 9.6%. Continued bad news will undoubtedly cause Canadian consumers to de-leverage further thereby eroding an already tepid recovery. 5

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

INVESTMENT MARKET TRANSACTIONS - Q2/2009 Property

Date

Price

Grosvenor Building

Jun-09

415 Yonge Street

Jun-09

1313 10th Ave SW

Office

Sq. Ft.

P.S.F.

Purchaser

City

$84.0 M

203,748

$412

Kingswood Capital

Vancouver

$32.1 M

191,880

$167

Crown Realty

Toronto

May-09

$15.0 M

47,144

$318

Estancia Inv'ts.

Calgary

Bentall V

May-09

$297.0 M

583,000

$509

DekaBank

Vancouver

Airways Pl. & Glenmore

Apr-09

$24.9 M

120,268

$207

Concrete Equities

Calgary

High Street House Metrotown Place III

Apr-09 Apr-09

$14.5 M $14.3 M

49,193 56,636

$295 $252

Highstreet House Metro Vancouv.

Calgary Vancouver

Property

Date

Price

P.S.F.

Purchaser

City

2751 Peddie Road*

Jun-09

$15.7 M

309,247

$51

1015-64th St East

Jun-09

$21.0 M

163,418

$129

ING Ind. Portfolio**

Jun-09

$19.7 M

306,820

$64

Cooper Constr. Toronto Churchill Properties Saskatoon Richcraft Group Ottawa

2340 - 22 St NE

May-09

$9.45 M

116,724

$81

City of Calgary

Calgary

2103 - 64 Ave

May-09

$18.4 M

251,959

$73

Private

Edmonton

10 Auction Lane

May-09

$7.0 M

99,614

$70

Greiner Pacaud

Sun Life Portfolio St Laurent Corp. Ctre

May-09 Feb-09

$28.3 M $18.0 M

343,803 197,752

$82 $91

Confidential Pension Fund

Calgary Edmonton

Property

Date

Price

Sq. Ft.

P.S.F.

Purchaser

1 Stafford Road

May-09

$7.8 M

36,600

$212

Richcraft Group

Ottawa

McKnight Village Mall Westoak Trails Plaza

May-09 May-09

$23.2 M $6.7 M

86,052 20,808

$269 $322

ICBC RioCan REIT

Calgary Toronto

Property

Date

Price

Suites

P.S.

Purchaser

City

Renaissance on Shaw

Jun-09

$12.0 M

111

$107,658

Raamco Internat.

Coquitlam

Sandringham Apartments

Jun-09

$13.0 M

100

$130,000

Ottawa

Manhattan Towers

Jun-09

$22.5 M

204

$110,049

Homestead Timbercreek

Greensborough

Jun-09

$10.5 M

$158,333

George Loh Ltd.

Coquitlam

20 Stone Hill Court

May-09

$14.3 M

151

$94,702

Homestead

Toronto

Briarwood Apartments

Apr-09

$9.2 M

$106,000

Beacon Hill

Edmonton

Sundial Apartments

Apr-09

$18.5 M

121

$152,893

Calgary Drop-In

Calgary

Arlington - 33 Banner Rd.

Apr-09

$22.5 M

220

$102,045

Ottawa

1971-1975 St Laurent Le Chatel - 1625 de Mais.

Apr-09 Apr-09

$37.5 M $36.7 M

500 300

$75,000 $122,333

Homestead District Realty Private

Industrial Sq. Ft.

Retail

Multi-Residential

Montreal

City

Toronto

Ottawa Montreal

*property was under construction and 50% complete at the time of sale **portion of Ottawa industrial porfolio, balance closing in 60 days

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

ACKNOWLEDGEMENTS Cited Research Resources

In the course of compiling the statistical information and commenting on real estate markets, national, regionally and across Canadian metropolitan areas, we acknowledge the assistance and feedback from the following parties in completing this report: AltusInSite, Bank Of Canada, Bank of Japan, BMO Economics, BMO Nesbitt Burns, British Bankers’ Association, Canadian Mortgage and Housing Corporation (CMHC), Canadian Mortgage Loans Services Ltd., CB Richard Ellis, CIBC World Markets, Conference Board Of Canada, European Central Bank, Federal Reserve Board, Frank Russell Canada (RCPI), The Globe and Mail, International Monetary Fund, Investment Property Databank Limited (IPD), J.J. Barnicke, National Post, PC Bond Analytics, RBC Capital Markets, RBC Economics, RealNet Canada, Scotia Capital, Statistics Canada, Torto Wheaton Research, Urban Land Institute and the US Department of Treasury

2009 ECONOMIC OUTLOOK AND MARKET FUNDAMENTALS Q2 UPDATE

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