2003EMERGING TRENDS IN REAL ESTATE® Emerging Trends in Real Estate Additional copies of Emerging Trends are is a registered trademark of available at $95 each from: PricewaterhouseCoopers LLP Lend Lease Real Estate Investments, Inc. Copyright © October 2002, 909 Third Avenue, New York, NY 10022. Lend Lease Real Estate Investments Attention: Emerging Trends and PricewaterhouseCoopers LLP or email requests to: All rights reserved. [email protected]
PricewaterhouseCoopers LLP 1747 Veterans Highway, Suite 48, Islandia, NY 11722 or email requests to: [email protected] 71515 p1_3.QXD 10/4/02 6:40 PM Page 1
DIFFERENT WORLD, TEMPERED EXPECTATIONS
Contents
Foreword 1 Chapter 1 Different World, Tempered Expectations 2 Chapter 2 The Survey: Investment Trends 2003 14 Chapter 3 Capital Flows 22 Chapter 4 Markets to Watch 32 Chapter 5 Property Types in Perspective 44
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EDITORIAL BOARD
Emerging Trends Chairs Patrick R. Leardo Fred N. Pratt, Jr. Editor/Author Jonathan D. Miller Editorial Board Lijian Chen Peter F. Korpacz M. Leanne Lachman Steven P. Laposa Jeanette Rice Robert K. Ruggles, III Susan M. Smith Paul Summer Dan Van Dyke Interviews and Surveys Conducted by PricewaterhouseCoopers Editorial Review and Production Cathie Bartels, Martha Althafer, Charlotte Decker, Donna Douglass, Ryan Dunlap, Caroline Green, Bernadette T. Korpacz, Marilyn Robson, Philip Thai, Bonnie White
The editors would like to thank our colleagues for their time and insights: Wally Antoniewicz, Cristina C. Ampil, Dan Bajadek, Jerry Barag, Timothy Barnes, Mark Bratt, Scott Brown, Dick Burns, Nicholas Cammarano, Jr., John Cherry, Gene Conway, Frank Creamer, Mike Daly, Ray D’Ardenne, Mark Degner, Andrew Friedman, Bjorn Hanson, Peter Harned, Doug Healy, Michael Herman, Larry Hicks, Ed Hurley, Scott Janzen, Boyd Johnson, Richard Kalvoda, Ted Klinck, Richard Marchitelli, Hugh McWhinnie, Don Miller, Paul Mucci, Scott Oran, Alan Plush, Jon Rosen, Jim Ryan, David Solis-Cohen, Joe Thomas, Michael Torres, Steve Walker, Richard Wincot 71515 p1_3.QXD 10/4/02 6:40 PM Page 3
FOREWORD
ommercial real estate investors watch nervously Don’t expect any sustained recovery before 2004 or 2005. as a sluggish economy offers scant relief from Its start should usher in a period of solid, unspectacular Cweakened supply/demand fundamentals. They performance that tracks traditional investing norms, with wonder whether the property markets are really a safe real estate nestling between stocks and bonds on the risk/ haven from the stock market cataclysm or simply the return spectrum. As investors become reconciled to more next asset class in line for major dislocation. Without down-to-earth returns — Wall Street’s unprecedented question, capital needs to raise its guard in the short decade-long bull run is over — income-oriented invest- term. History shows that increased flows to real estate in ments like real estate should look increasingly attractive. softened markets can mean problems for investors. So far, low interest rates have been a boon to owners, who’ve This consensus view is detailed throughout Emerging Trends, been able to refinance or leverage up returns. And the industry’s most respected outlook, now in its 24th year. development has cooled down, keeping supply under The forecast is published jointly by Lend Lease Real Estate reasonable control. But demand — especially for office Investments and PricewaterhouseCoopers. More than 170 space — has cratered in many markets and shows no industry experts — investors, developers, lenders, brokers, signs of ramping up quickly, absent a sudden rebound in research consultants — participated in the detailed corporate America. interview/survey process that once again forms the basis of Emerging Trends. PricewaterhouseCoopers conducts that For 2003, Emerging Trends in Real Estate forecasts a process and Lend Lease writes and produces the report. Both continuation of lackluster performance, as markets companies provide additional research and executive insights. struggle to escape from a relatively shallow, but extended, cyclical downturn. On a relative basis, real estate may All of us at PricewaterhouseCoopers and Lend Lease extend sustain returns that continue to beat stocks and bonds, our considerable appreciation to the respondents and but robust gains are not expected. Overall returns should interviewees. Their candid insights are responsible for hover in the mid to upper single digits; however, Emerging Trends’ unmatched track record for predicting commodity properties with vacancy problems could market movements over the years. 2003 promises to be a suffer serious declines, since capital will focus on choppy, maybe even challenging, period in the property premium, well-leased buildings with locked-in cash flows. markets. We hope this report helps guide your success through the year.
PricewaterhouseCoopers LLP Lend Lease Real Estate Investments, Inc.
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DIFFERENT WORLD, TEMPERED EXPECTATIONS
When plentiful capital cavorts in ith Emerging Trends forecasting an anemic rebound — a gradual upturn that should commercial real estate markets Wgain momentum in 2004-2005 — investors would do well to continue seeking quality properties with with eroding fundamentals, it’s locked-in income streams that will carry them through the market trough. Marginal properties in marginal locations time for more caution. Despite the could suffer material value declines, as capital and tenants steer clear.
current proclivity to park money in After an unusually steep bust-boom trajectory in commercial real estate, the investment universe is reverting seemingly safe property harbors to the mean — the middle ground between the early ’90s recession and the late ’90s skyrocketing of the stock market. instead of the bloodied stock More recently, the vicious bear market in stock equities, collapse of the high-tech and telecom industries, and market, an ominous trio — rising ensuing corporate governance scandals have soured notions of easy money, early retirement, and carefree speculation. vacancies, declining rents, and Shock waves from September 11 have administered a long- overdue dose of reality for many Americans — security and mounting property expenses — order can’t be taken for granted in an increasingly complex and dangerous world, despite our country’s lone promises increasing pain in 2003. “superpower” status and dominating economy. “It’s a If the economy flounders, the year different world, and expectations are tempered.” For investors, the recent tumult has been a wake-up call to ahead will see a relatively concentrate once again on risk-adjusted returns and regain reasonable expectations about investment performance. shallow property-market downturn Ultimately, this renewed focus should reward real estate as a steadfast haven for solid, income-oriented returns, sitting prolonged and core portfolio appropriately between high-grade bonds and more volatile stocks on the risk/return spectrum. “Long-term returns for returns concentrated in the mid to core real estate should deliver about 5% (above inflation), and over the next five to seven years we should expect upper single digits (albeit safely total returns in the 7%-8% range,” predicts a leading real estate strategist. “That’s maybe not as dynamic as you in the black). might like, but there are coupons to clip, and in light of recent stock market experience, those returns will be quite nice indeed.”
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“WHEN YOU LOSE 35% ON YOUR STOCK PORTFOLIO, SINGLE-DIGIT REAL ESTATE RETURNS LOOK GOOD TODAY.”
Controlled Capital Flows It’s not just window Completing a dressing: Scrutiny by the CMBS B-piece cartel, rating agencies, and Wall Street REIT analysts has actually Comeback imposed considerable restraint on lending activity and helped stanch unnecessary development. “Nobody’s acting Most indicators show real estate surviving a torpid 2003, to stupid — you can’t get away with it.” emerge with regained standing in the investment universe and greater structural stability. That’s assuming we avoid an Attractive Yields Apartments, 24-hour office, grocery- ugly double-dip recession or global maelstrom — read: war anchored retail, prime malls, and warehouses have proved in Iraq, cataclysmic terrorist strike, Middle East confla- they can deliver 7%-8% income consistently. gration, God knows what — in which case all bets are off for all investment categories. Positive Returns Most importantly, real estate appears to be surviving a cyclical downturn without major dislocation. Greater Structural Stability Recent REIT and The property sector is regaining a large measure of its pension fund dominance of the equity markets means the reputation as a reliable, less mercurial, bond-plus investment industry isn’t as leveraged as in the past, when private — an image severely damaged in the early-’90s market owners held sway. “Owners have more skin in the game,” depression. “When you lose 35% on your stock portfolio, and the public operating companies have brought greater single-digit real estate returns look good today.” sophistication to the job of understanding markets and managing investments. REITs, especially, tend to be agglomerators — buying and holding prime properties, 2003: More Risk, selling only weaker assets as necessary. “The industry’s capital structure won’t be as active, there’s not the pressure to sell, and there’s greater overall stability.” Little Upside The flip side is a host of challenges that will make 2003 a problematic year for investors. Investors need to focus on the EXHIBIT 1-1 “three Ds” — dividends from quality properties, discounts, NCREIF Returns vs. S&P 500 and diversification. “Real estate’s attractiveness has been NCREIF RETURN income security, and that security could come under stress S&P 500 the longer the economy stays down.” Here’s why: 40%
30% Sublease Overhang Although real estate execs crow about development staying in relative check across most 20% sectors (and it has except in suburban office), the impact of 10% office overleasing by companies with unrealistic appetites for expansion at the height of the tech bubble caught 0% “everyone by surprise.” Post tech-wreck, the flood of -10% sublease space has been dramatic and unprecedented, -20% pushing office vacancy rates up even more sharply than in ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q ’02 the late-’80s deluge of overbuilding. Corporate Belt-Tightening and Phantom Sources: Standard & Poor’s, National Council of Real Estate Investment Space While advertised as a mild economic downturn, Fiduciaries, Rosen Consulting Group the 2001-2002 recession — coupled with stock market
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contagion, 9/11 wounds, and fallout from Enronesque EXHIBIT 1-2 meltdowns — has hit many companies hard. Bosses “Prime” Lending Rate continue to redline budgets, whacking expenses (including travel) and imposing hiring freezes. Empty cubes populate 25% many offices on top of the sublease surfeit. When an 20% economic recovery gains steam, plenty of leased and
underutilized “phantom” vacancy will need to be absorbed 15% before tenants can expand into new space. “This has been a corporate depression after a corporate boom, and the effects 10% haven’t fully played out yet,” warns a well-known real estate researcher. “Any recovery in office occupancy could be very 5% slow.” A portfolio manager adds: “I’d be tickled to death if 0% someone told me we’d be headed up by 2004.” ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 Aug. ’02 Downward Rents, Rising Expenses Increasingly, Sources: Federal Reserve Board, Rosen Consulting Group empty sublease space will roll over, hurting property revenues. “It’s real estate’s version of the bear market.” jitters subsided, have cushioned the downside — the lodging Rents in many markets have backed off their late-’90s industry has remained profitable. Still, cost-conscious spikes entirely and then some. In some markets, corporate customers put downward pressure on room rates. concessions have returned, including free rent and lavish Until companies start expanding operations again, hotel tenant allowances. Expenses, meanwhile, march up — revenues will grow only moderately. Airline route and service especially for insurance and security, courtesy of 9/11. cutbacks won’t help either in the short run. Overall, the Cash-strapped local governments are raising taxes, and impetus to travel has waned for road warriors. labor costs continue to increase. Pinched rent rolls and Stressed Consumers Retail properties have benefited higher operating costs aren’t a favorable combination, even from enduring consumer confidence and spending. “It if office owners can pass on some major expenses to seems Americans were put on earth to do one thing — existing tenants under lease terms. But the more vacancies shop — and they’ve been doing it no matter what.” increase, the more costs landlords must absorb directly. Discounters have been the big winners at the expense of Passing on expense hikes is even harder for apartment and mall department stores. Grocery-anchored strip centers — hotel owners — their soft occupancies make raising rates despite continuing supermarket chain consolidation and practically impossible. Recessions are notorious for driving Wal-Mart’s incursion — also have held up well. Relatively apartment renters to double up or move back in with Mom low unemployment rates (well below those in previous and Dad. It’s been no different this time. In addition, recessions) and historically low interest rates have kept intoxicatingly low mortgage rates have encouraged some shoppers in stores. But the record levels of consumer debt renters to buy. Overall, demographic trends remain sound are worrisome. “At some point the individual has to get for multifamily, but 2003 will be less than robust until job stressed — look at the levels of consumer debt, plus and wage growth start to kick in. mortgage debt and all the depleted stock portfolios out there.” Hotels wobbled after the September 11 terrorist strikes literally shut down business and tourist travel. But operating Interest Rates: Nowhere to Go but Up? Low efficiencies introduced over the past decade, plus reduced interest rates have been “an intravenous line” for the real development and a gradual rebound in bookings after flying estate markets — “delaying distress,” “masking performance
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“THE DREAM IS THAT THE ECONOMY REBOUNDS BEFORE WE NEED TO RECOGNIZE THE CRUMMY FUNDAMENTALS.”
issues,” propping up returns, and possibly inoculating premier holdings — bidding for B malls and office investors against any severe impacts. Owners aren’t forced buildings with more questionable rent rolls, using a leverage to put flagging properties up for sale or into delinquency formula — could be courting trouble over time. “This is — they can refinance and still meet low floating-rate debt The Picture of Dorian Gray scenario. What looks good payments in periods of weakened cash flow. Put another today will show up ugly tomorrow. You could be cooked in way, low rates raise returns, making sales unappealing. But a heartbeat if you miscalculate. There could be disinter- rates have fallen about as low as they can go, unless the Fed mediation between pricing and value. These deals won’t starts worrying about those two particularly bad-news meet return expectations down the road without debt scenarios, double dips and Japanese-style disinflation. staying down.”
Plainly, “an unexpected rate rise is the market’s biggest Overall, a key for 2003 “will be monitoring capital flows. risk.” Increased government borrowing and deficits could Where capital flows go, values will hold up. Where capital push interest rates higher, and most observers expect some pulls out it could be a difficult year, because the modest and manageable hikes in 2003. While unlikely, “hit fundamentals aren’t that good.” the panic button if rates go up too fast.” That would mean heartache for investors who have been counting on low Anemic Economy If an economic recovery starts interest rates and attractive floating-rate leverage to weather sooner rather than later, any damage to real estate markets cyclical squalls, especially if sublease space starts dropping should be very manageable. “The dream is that the off the rent rolls and rates slide further. “You’re gambling economy rebounds before we need to recognize the that interest rates stay low. In the end it’s ‘where’s the beef, crummy fundamentals” — companies grow and absorb where’s the tenant.’ You’ve got to work the properties — vacancy, unemployment declines, wages go up, spending keep the tenants in line and paying rent — or you could increases…the good things in life, like hotel stays and mall be in trouble.” splurges, return in force. Realistically, while Emerging Trends interviewees do anticipate an economic recovery in 2003, The Capital Crutch Real estate’s other crutch has been an overwhelming majority — more than 90% — expect a heady flow of capital looking for high ground in the wake low to moderate growth, and nearly 60% are in the slow- of stock market devastation. Most investors have been growth camp. Optimism is in short supply. reasonably disciplined, buying prime income-generating properties — well-leased 24-hour office, apartments, EXHIBIT 1-3 warehouses, and grocery-anchored retail. “All the capital Real Estate vs. Economy means there are no steals out there.” The flight to quality has GROSS DOMESTIC PRODUCT TOTAL NCREIF RETURN sustained values, lowered cap rates, and paradoxically created 20% a great “sellers’” market for quality properties in the midst of 15% rising vacancies and economic doldrums. Buyers have looked to lock in 7%-8% yields and leverage up with cheap debt. 10% Solid credit tenants and rent rolls should see them through 5%
any near-term market hiccups. Properties with these 0% “reliable” risk-adjusted returns, albeit pricey, are just what the -5% doctor ordered after a bad case of WorldComitis. “I’d make -10% these deals all day.” ’83 ’86 ’89 ’92 ’95 ’98 ’01 2Q ’02 Weaker properties in fringe markets remain off investor Sources: U.S. Department of Commerce, National Council of Real Estate radar screens entirely. Investors who take a step down from Investment Fiduciaries, Rosen Consulting Group
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Indeed, after a go-go decade where many businesses In last year’s report interviewees warned that opportunity overindulged and overreached, the roar seems to be out of funds were flagging — their claims of future 20%-plus the economy. Most observers are “perplexed” and hard- returns essentially “marketing hype” and “wishful pressed to identify the next growth engine. Tech and thinking.” This year, some interviewees are calling for last biotech will rebound, but not immediately. The Internet is rites. “The opportunity phase is over. Maybe you can pump still a driver, but its impact will be more restrained than up returns with high leverage (up to 90%) into the mid to during its frenzied start-up phase. Telecom is flat on its high teens. We’re not in a get-rich-quick business today. back. No doubt, a “new-new thing” will evolve, but it’s not We’re in a get-rich-slow one.” discernible on the horizon. A defense build-up will help Even some opportunity fund managers grudgingly admit markets with military contractors and suppliers, and a stock that “it’s hard to put money out.” A few fringe niches exist market rebound would put more juice back in the system, — freezer warehouses, assisted-living homes and other helping frazzled financial companies in particular. senior housing. But whispers abound that funds are Expected 2003 Scenario: Doldrums, returning new commitments to investors, with some Not Despair Interviewees keep their fingers crossed managers getting whipsawed in declining markets as they that office vacancies will start dropping in the second half try to cash out mature funds. “The world has changed. of the year, with some modest upward pressure on rents in Investment banks are actually talking about starting core stronger markets by early 2004. Properties with solid tenant funds now.” rosters and little near-term rollover exposure should sail Although shallow recessions and real estate troughs seldom through. “Those leases provide embedded value.” Expect precipitate the widespread market dislocation that oppor- the major, supply-constrained 24-hour cities and subcities tunity vultures crave, we can expect enough distress to to bounce back faster. Suburban office has weaker prospects provide some higher return possibilities in formerly hot tech and few adherents. Warehouses, apartments, and grocery- markets — Silicon Valley, Seattle, Austin, and even the anchored retail should hold their own. These sectors have Boston suburbs. “The next wave of opportunity will consist softened, but not dramatically; they’re positioned to of highly leveraged owners who borrowed on floating rates, muddle along, rebounding with any economic growth. or have been hanging on because of low interest rates, and Hotels, having survived 9/11’s aftermath, can only get get caught as rates go up again. When fundamentals take better. “We’re in for more doldrums: not much of a over, leverage can bite you in the butt.” recovery, no real despair.” But don’t be fooled about 2003 — there is more downside risk than upside potential. Some mistimed office developments could also be hurting in a slow leasing environment, requiring a bailout or Whither Opportunity? recapitalization in the face of see-through vacancy. While pro forma rents were more conservatively underwritten The Emerging Trends forecast for a return to historic norms than in the late-’80s overbuilding binge, empty buildings and a reversion to mean implies that real estate still don’t generate cash flows. performance in the next up-cycle will be driven primarily by current income — not so much by value appreciation, Cyclical or Secular? which contributed to prodigious gains in the late 1990s. Clearly, appreciation will be hard to come by in 2003. Weary of their second-class status, many real estate pros are “Investors are now looking for preservation of capital, not viewing the recent Wall Street carnage, and the ensuing tide shooting the lights out.” of flight money heading their way, as retribution — a sign of
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“CAPITAL IS MORE PLENTIFUL THAN EVER FOR REAL ESTATE, BUT IT’S EXTREMELY DISCIPLINED.”
redemption. They hope “cap rate compression is here to stay” EXHIBIT 1-5 and point to stabilized markets like Europe’s, where yields are Spreads Between Real Estate Yields lower and capital is plentiful. and 10-Year Treasuries Most interviewees see the flood as temporary. When the 450 stock market recovers, they say, money will pull back from 400 real estate. “The secular talk is coming from guys making a 350 300 deal who want approval from the investment committee,” 250 212.0 average (3Q’65 - 1Q’02) says a leading broker. 200 150 Some worry about an extended Wall Street hangover. “If 100 the stock market doesn’t recover — then it’s a lose-lose for 50 everyone, including real estate. If the stock market does 0 heal, then capital will move back into stocks.” ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 2Q ’02E But real estate should hold its own and continue to enjoy Sources: Haver Analytics, American Council of Life Insurers, Rosen Consulting Group an improved image — absent any nasty surprises from investor overpaying and overleveraging in the current down market. In time, further real estate cap rate compression Treasuries, providing investors a comfortable premium (see wouldn’t be surprising as various asset classes, including Exhibit 1-5). Attention will also come from pension funds stocks, return to more “normalized” returns in this and other institutional investors looking for solid income- reversion-to-the-mean process. “Cap rates have been oriented returns to meet the retirement entitlements of too high, because capital was overallocated to stocks graying baby boomers. “Sympathy for real estate is very for so long.” strong. Where do you get yields today other than real estate?”
In fact, cap rates have room to fall further — they’re still Also, foreign investment is increasing, retail investors are above historical averages (see Exhibit 1-4). Real estate yields, coming back, and, increasingly, companies are establishing meanwhile, continue to enjoy a very favorable spread over real estate 401(k) options in investment plans. Solid income performance and disciplined markets will guarantee greater EXHIBIT 1-4 liquidity for the asset class. Rather than a paradigm shift, real NCREIF Cap Rates estate is experiencing a “back to the future” return to the roots of its traditional investment allure. 10.0% 9.5% 8.0% What’s a Credit Tenant? 8.5% A year ago a landlord with WorldCom, Arthur Andersen, 8.0% and Enron signed to long-term leases could rest comfortably 7.5% Historical Average 7.79% — no Internet startups without balance sheets on this roster. 7.0% These guys were all certified credit tenants. Suddenly, sound 6.5% sleep turned into nightmare. Office markets got a turbulent 6.0% ’78 ’80’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q taste of what retail real estate owners had been experiencing ’02 for years from the likes of Kmart (in bankruptcy), Ames (in Sources: National Council of Real Estate Investment Fiduciaries, liquidation), and Montgomery Ward (long gone), to name a Lend Lease Research
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few of the vanished stalwarts. “A great name isn’t everything reduce volatility and help stabilize the markets,” says a top anymore.” transaction executive. Another adds that REITs and pension funds “don’t have the gunslinger developer mentality,” and Understandably, the question of how to protect against lenders are holding the reins on construction loans. The sudden carnage has most interviewees flummoxed. “You’ve development business just isn’t as profitable as it used to be got to look at an established, long-term track record,” when easy money, high loan-to-value ratios, and low debt ventures a portfolio manager. Well, that might have worked service coverage were the norm. for dismissing an E-wannabee or dot.gone, but not for a Big-Five accounting firm. Despite ample capital, the majority of equity players have remained reasonably careful and have focused on bidding Simply, real estate owners need the same protections that up mostly the crème de la crème, effectively bifurcating stock investors require in evaluating the soundness of the transaction market between “have” properties (with companies — more reliable and honest accounting of tenants and delayed rollovers) and “have-nots” (with higher company performance and balance sheets. Until corporate vacancies and inferior locations). “Everyone who measures reporting shakes out, claims about credit tenants can’t be transaction volume will have seen another down year in taken for granted. 2002, and that’s due to discipline and sheer lack of oppor- tunity. But we need to look out for overpaying in this sort Keep a Tight Rein of environment where the money is flowing.” High-net-worth investors have been a force in the capital If investment discipline starts breaking down in the real estate markets, but more concern is trained on syndicators, who markets, look for lenders to lead the way in bad underwriting. are back after a 16-year hiatus, raising money from Debt accounts for more than quadruple the volume of equity individual investors for various partnership deals. The last investments, and lenders have historically greased the syndication bubble burst after a tax-shelter-driven buying development skids, leading to oversupply in past market spree fueled a development round of questionable hotels downturns. But fortunately, the last market nadir preceded and office buildings, most of which went bust. Com- and helped give rise to the CMBS business, and CMBS buyers missioned brokers are out raising money again, now — in particular the B-piece cartel — now rule the roost. “If pitching the “safe haven” story instead of the tax shelter B-piece buyers refuse to take loans made on properties where line. “The investors are unsophisticated — many are old there may be overbuilding, then loans won’t get made.” ladies in tennis shoes.” The various private real estate CMBS issuers know loans that don’t meet tough cartel players marketing these investments through banks and underwriting standards will get rejected from pools; and money managers bear scrutiny. “There’s been some buying whole-loan lenders — commercial banks and life insurers — above replacement cost.” Have you read that Oscar Wilde who want a future securitization option for their portfolios novel about Dorian Gray? are following CMBS structures and standards in fairly close There’s not much slack for making mistakes and ignoring lockstep. “Capital is more plentiful than ever for real estate, market fundamentals. Smart money will be very selective but it’s extremely disciplined,” says a top conduit executive. during the year. Dumb money doesn’t have much of a “The B-piece cartel is doing its job.” safety net. Even some former skeptics admit that expanding commercial mortgage market influence can help control capital flows and tamp down irrational investing. “I’m finally buying into the concept that the public markets
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TERROR’S UNSETTLING LEGACY Terror is not an isolated phenomenon in or was America immune prior to September 11. Whether people took note or not, the U.S. has the contemporary world. Israel endures Nbeen an Al Qaeda target for more than a decade. We gave the 1993 World Trade Center incident momentary constant attacks. Bombs have been attention, but moved on quickly. The seemingly impervious buildings were hardly touched — never mind the handful exploding sporadically in European of casualties. Overseas, a truck bombing of a Saudi capitals for years — London and Paris apartment building complex and a suicide motorboat attack on the USS Cole targeted our military — it comes have been favorite targets. Highly with the territory. The Embassy bombings in Africa were, well, in Africa — far, far away. Of course, Oklahoma City visible, machine-gun-toting police are showed how easily an office building could be destroyed even here, but it was treated as a horrendous aberration, the staples in most countries — work of a nutcase directed at the government. Life goes on. democracies as well as repressive And life goes on after 9/11, no matter how searing the destruction of our biggest city’s tallest buildings. “We all states and banana republics. The Tokyo have short memories” and we’re not letting it rule our lives. “The farther away from New York City you are, the less subways suffered a deadly cult-inspired things have changed.”
poison gas attack. In Russia, a rash of But unquestionably, September 11 riveted America’s attention, changing attitudes about our security and our devastating apartment-building sense of place. Everyone realizes that we’re more vulnerable — that American shores are no longer unassailable. Indeed, bombings continues to this day. The another attack could happen suddenly — maybe sooner list of horrific incidents is endless, rather than later, and who knows how or where. At the margins at least, 9/11 has changed how we think about stretching to every continent. where we work, live, shop, and play. Here are some of the impacts on real estate:
The Need for Perceived Security
mployees now rank safe environments as a prime job satisfaction issue, and corporate tenants Eincreasingly insist that building management provide enhanced visibility of security. “So you show it at the entrance where everybody sees it, as opposed to behind the scenes where they don’t,” says a property management executive. Most workers gladly put up with the added
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inconvenience of more thorough screening. And while ID card EXHIBIT 1-6 checks at elevator banks won’t keep another 9/11 from Impact of Terrorism on Skyscrapers happening, the increase in “live body security” and locked doors with cameras is controlling petty theft. Building crime is Some way down. 57.8% None 0.6% New Mindsets Significant 41.6% hat was inconceivable 18 months ago has become possible today — from suicide bombings in malls to bioterror in city centers. W Source: Emerging Trends in Real Estate 2003 interviews Nothing can be dismissed out of hand. Everybody at least considers “what if” scenarios and personal escape schemes in case of a new event. Some plans are well thought out; some EXHIBIT 1-7 maybe don’t make a lot of sense. “I’d rather be high than low Negative Impact of Terrorism on Real Estate in a building, if it were to get hit by a truck bomb,” says a 99.2% 95.8% 97.2% 96.0% prominent executive in Chicago, figuring that what happened 100% in New York won’t be repeated. At least, everyone pays more 76.3% 80% attention when building management conducts fire drills, and 63.3% 58.3% hopes “it” won’t happen — whatever it may be. 60%
40% Pricing and Icon Reluctance 20%
0% or the most part, terrorism hasn’t affected pricing CBD Suburban Regional Industrial Garden High-rise Full- Office Office Malls Apts. Apts. Service calculations. It may be an issue for a handful of Hotels landmark skyscrapers in the biggest cities, and possibly F Source: Emerging Trends in Real Estate 2003 interviews a few neighboring buildings. “It’s there in the back of your mind, absolutely” when you consider these properties. So far, the issue has been academic — not one has been put on the block. But some interviewees see “permanent impairment” to Accepting Uncertainty the highest-profile skyscrapers. Then again, there always seem to be ego investors who want the biggest and the best. “As we ho knows what the terrorists will target next — move further away from the incident it gets more abstract.” a mall, a stadium, a small town in Kansas? Over time, people will become less concerned. “Buyers are “Don’t be blinded by what happened last time.” getting more comfortable with larger offices and hotels as time W We’re not facing the planet’s total annihilation by nuclear war. passes.” For now, though, it feels better to own a Brand X or Terrorism constitutes more random violence and is somehow plain vanilla building than a branded high-profile tower or more personal. A few folks bolted from Park Avenue co-ops icon corporate headquarters. Too-high-profile status also may to Hampton hideaways after 9/11. But would the threat of a hurt some high-rise apartments. Glitzy, cloud-level views aren’t dirty bomb at the State Department really make you move all they were cracked up to be — at least for the moment. See out of your Georgetown townhouse? Most people have just Exhibits 1-6 and 1-7. stayed put.
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THE INDUSTRY IS RELUCTANTLY COMING TO GRIPS WITH ADDED, BUT “MANAGEABLE,” COSTS FOR COVERAGE.
Dispersion Security and Safety Costs
he events of September 11 highlighted a e’re also seeing significantly increased expenses corporation’s vulnerability when operations are for security and life safety improvements, many Tconcentrated in one location. That’s always been Wof which will become permanent and necessary the case “whether in a nuclear attack or when a backhoe by law. Some cities — including, not surprisingly, New York cuts through a fiber-optic cable.” Reverberations of 9/11 — are moving to enact more stringent building codes. For meant business leaders couldn’t ignore the issue any longer, starters, security costs have increased from 50 cents up to $1 if they hadn’t tackled it already. Most large companies have per square foot in large multitenant office buildings in major reevaluated where functions should be located, moving markets. Managers struggle to provide rational improvements pieces of businesses in and out of cities to ensure that back- without letting costs get irrationally out of hand. Evacuation up facilities and computer systems are secure. “It’s unwise planning is now a much bigger concern — tenants want to to have all key decision-making in one place.” But no sea know about the structural integrity of escape routes. Special change has occurred. Suburbs haven’t benefited attention is focused on parking decks and garages, where conspicuously at the expense of cities. bombs can be planted in entering vehicles. The anthrax scare has made improved security of HVAC systems a greater priority, but retrofitting filters and air pressure devices can be extremely costly. Aside from putting extra security cameras at Insurance Hubbub likely intake locations, most building owners are taking little immediate action. The federal government, meanwhile, looks furor over terrorism insurance was another to mandate tighter security, including more concrete and consequence of the World Trade Towers collapse. metal barriers, at properties where it leases space. Will AThe industry is reluctantly coming to grips with Washington, D.C., look more like a bunker than it already added, but “manageable,” costs for coverage. “The market does? Expect cities to upgrade building code requirements for is sorting the issue out” for most properties without waiting various safety measures in new construction — structural for a government backstop. “Insurers made back the dollar reinforcements; wider, more resilient stairways; more fail-safe they lost, and maybe then some.” Obtaining coverage is no communication systems; less vulnerable HVAC. These code longer a roadblock for smaller property transactions, as changes will add costs and could “help put a lid on new lenders back off from coverage requirements. For higher- development” in major markets. profile buildings, insurance coverage remains a major impediment to refinancing and salability. “The govern- Less Impact in the Hinterlands ment will need to step in here until the market finds a solution.” Institutional buyers and REITs use blanket utside the big cities, security and safety concerns policies spread over their entire portfolios to cross- are muted. In suburban Atlanta, increased office collateralize assets, reduce overall costs, and limit exposure. building security may mean the lobby guard They have a big advantage over buyers who don’t have O asking you to sign out after hours. “In Philly, we’re not on scale. But as a major REIT executive cautions: “Ultimately, the radar screen of terrorists,” insists an interviewee. But there is nothing you can do to insure against these acts.” In who knows for sure? What about Boca Raton, where the short, deals get done despite added costs and hassles. The first Anthrax letter closed down an office building after a moment we have another terrorist attack, the issue will tenant died? And can Oklahoma City even remotely be revive big-time. considered a 24-hour market?
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Downtown New York Regional Mall Jitters
ronically, the Manhattan financial district finally has a all owners are attempting to meet “the public’s chance to completely refashion itself into a true 24- expectation for security.” Some major mall REITs Ihour city — with increased residential, cultural, and Meven buy bomb dogs for additional perceived park space, plus an outstanding transportation hub that surveillance protection. “But if someone wants to do some- would link with surrounding suburbs. Despite losing 13 thing, they’ll do it,” says a leading regional shopping center million square feet of office space (as much space as in executive. Who is under any illusion that malls wouldn’t make downtown Atlanta), the area is bouncing back better than great terror targets? Everyone’s fingers are crossed. anyone could have expected — neighborhoods are reviving. Now the powers-that-be need to sort out various redevelopment proposals to ensure that the city comes out ahead after its considerable suffering. Keeping the stock Hotel Vulnerability exchanges in the district is also essential. For sure, little appetite exists for constructing a new landmark target, let he industry cringes at the thought of another alone rebuilding the Towers. terrorist incident compromising travel. The Tlodging business is always more exposed to sudden Immigration Shortage economic or global jolts than other property sectors, and acts of terror can instantly send revenues plunging, ighter visa restrictions and a continued 9/11 especially if airplane safety becomes suspect. undercurrent against immigration will damage Tgrowth prospects for larger gateway markets like New York, Southern California, San Francisco, Miami, the Warehouse Redux large Texas cities, and Chicago. In particular, slowed immigration — down 30% for the first half of 2002 — will soften a substantial demand driver for rental he 9/11 attacks “exposed flaws” in the just-in-time apartments in these markets and shrink the labor pool that supply chain when some key-manufacturer supports service industries. Over time, the nation’s Tshipments got tied up at border crossings or in economy will suffer. “We need to sustain immigration shut-down airports. Plain vanilla warehousing regains some growth to keep the economy going and avoid labor cachet vis-à-vis big-box distribution complexes, as shippers shortages,” says a leading researcher. build more of a safety net into logistics planning for just- in-case requirements. But just-in-time endures, and overall Renter Scrutiny demand for space may ultimately increase as a result.
partment tenants and prospective renters face increased scrutiny and background checks. Some Alandlords are undertaking more frequent unit inspections and placing limitations on deliveries. But owners need to be careful about brushing up against Fair Housing laws.
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THE SURVEY: INVESTMENT TRENDS 2003
Today’s sluggish economy won’t he Emerging Trends interviewees confidently predict that both private equity real estate and real boost lagging real estate Testate securities will outperform stocks (77% of respondents) and bonds (92%) during the year. Overall, fundamentals. Until later in the respondents see private equity outperforming REIT stocks year, property cash flows — by a slight margin. Once again, respondents favor income-oriented investments especially in the office sector — — industrial warehouses, apartments, and grocery-anchored shopping centers. These sectors have weathered the market could be stressed. With looming trough better and are expected to continue delivering uncertainties clouding their crystal consistent, reliable cash flows through a slow recovery phase. Dominant fortress malls also have a strong coterie of balls, the interviewees are followers for the same reason. Office properties — especially suburban — could decline more before stabilizing and sending mixed signals about the improving. Rising vacancies have undercut rental rates, disconnect between robust capital and demand indicators aren’t promising. Research and development (R&D) space will also struggle — the tech availability and languishing wreck has taken its toll. The worst is over for full-service hotels, but investor interest is skittish. Once again, limited- demand for space. A shift of service hotels and power centers have fewer adherents. Markets are highly bifurcated, with capital clinging to capital back into the stock market premium assets and avoiding almost everything else. could undercut values abruptly, and interest-rate hikes could Asset Class Investment Potential for 2003 Rating stretch some borrowers, 10
prompting defaults and distressed 8 6.4 5.9 selling. But if the economy gains 6 4.7 4.7 4.8 4.6 4.3 3.9 momentum ahead of predictions, 4
spurring office leasing activity and 2 business travel as well as 0 Money High- U.S. High- Int’l Global Real Real buttressing consumer confidence, Market Yield Stocks Grade Real Invest- Estate Estate Funds Bonds Bonds Estate ments (Private) (Public) real estate returns will be buoyed. Stocks Ratings for charts in Chapter 2 are based on the 0-to-10 (poor to excellent) scale. Source for exhibits in Chapter 2: Emerging Trends in Real Estate 2003 interviews
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“VELOCITY OF LEASING AND RENT GROWTH ARE ALL TIED TO THE ECONOMY AND JOB GROWTH.”
The Economy Nearly 60% of interviewees anticipate a Pricing, Yields Prices and yields will generally stagnate flat to low-growth economy in 2003 — not the type of or track slightly downward, according to interviewees, high-grade-fuel elixir to jolt real estate out of its cyclical reinforcing the view that real estate labors to regain some funk. Almost 40% forecast medium growth. Hardly anyone thrust. The three perennial cash-flow kings — apartments, expects either a double-dip recession or a sharp upturn. The warehouses, and grocery-anchored retail — show the best sooner the economy gains traction the better for real estate prospects for increased pricing. Buyers flock to them, markets, but optimism is restrained. “Velocity of leasing and pushing yields down. Outlooks for other sectors, including rent growth are all tied to the economy and job growth.” the dominant office category, are weaker. “Realistically, cap rates are irrelevant in the current markets. It’s underwriting Market Environment The resulting climate for that counts.” investment will be mediocre, scoring 5.6 on the Emerging Trends interviewee rating scale of 1 to 10 (poor to Value Changes Value-change predictions present a excellent). Low interest rates should propel financing mixed bag. Suburban office deteriorates (-2.1%) and opportunities, which register a stronger 6.0 rating. But downtown office stagnates (-0.1%). As expected, R&D also sentiment trails markedly for development, with soft slides (-0.7%). Other categories show upticks, supporting markets offering little opportunity for new construction. the view that a turnaround will get under way. Leading
Rate Outlook: 2003 and the Next Five Years Anticipated Price and Yield Changes: 2003 RESPONDENT RATING 2003 NEXT 5 YEARS PROPERTY TYPE PRICE CHANGE YIELD CHANGE Increase Warehouse Up Down Apartments Up Down 6.5 6.3 6.4 5.7 5.5 5.8 5.6 5.6 Community Shopping Centers Up Down 5.1 4.8 Regional Malls Stagnant Stagnant/Down Stable Downtown Office Stagnant/Down Down Power Centers Stagnant/Down Stagnant/Down Suburban Office Down Down Decrease Research & Development Down Stagnant/Up Short-Term Corporate Inflation Comm. Real Full-Service Hotels Down Stagnant/Down (Money Bonds Mortg. Estate Limited-Service Hotels Down Stagnant Market) Rates Yields
Capitalization Rate Bid/Risk Characteristics Value Changes BID/ASK SPREAD PROPERTY TYPE 2003 5-YEAR 10-YEAR PROPERTY TYPE BID ASK (BASIS POINTS) DEAL Apartments 8.5% 8.0% 50 8.3% Community Shopping Centers 4.4% 12.6% 22.4% Regional Malls 8.7 8.1 60 8.4 Warehouse 3.5 12.8 22.6 Downtown Office 9.1 8.5 60 8.8 Full-Service Hotels 3.0 12.1 22.3 Warehouse 9.1 8.5 60 8.9 Apartments 2.5 14.6 28.5 Community Shopping Centers 9.4 8.8 60 9.1 Limited-Service Hotels 1.6 10.2 18.3 Suburban Office 10.1 9.3 80 9.7 Regional Malls 1.3 11.2 19.9 Research & Development 10.0 9.4 60 9.8 Power Centers 1.2 8.5 15.9 Power Centers 10.4 9.6 80 9.9 Downtown Office (0.1) 12.2 24.5 Full-Service Hotels 11.3 10.0 130 10.7 Research & Development (0.7) 9.8 17.6 Limited-Service Hotels 12.5 10.9 160 11.7 Suburban Office (2.1) 10.9 21.9
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the way are grocery-anchored retail (4.4%) and warehouses buy, sell, and hold recommendations for 2003. Strong (3.5%). Full-service hotels rebound with a 3.0% gain, while sentiment exists for holding office, full-service hotels, apartments are up 2.5%. Recent survey laggards — regional R&D, and regional malls. Clear buy signals register for malls, power centers, and limited-service hotels — all warehouse. Interviewees clash over apartments and grocery register some appreciation, underlying interviewee retail — buyer demand has pushed yields down to confidence that markets will be headed upward by year-end. extremely dear levels. It’s probably a better time to cash out or at least winnow portfolios. The more definite sell alarms Buy, Sell, Hold At a typical market bottom, buyers are sound for limited-service hotels and power centers. But favorably positioned and owners want to hold until a attitudes regarding these sectors have actually improved recovery takes firm root. It’s never a particularly good time from past surveys. to sell. However, the shift of capital from the stock market toward real estate has buttressed pricing for prime properties, creating opportunities for sellers and driving down yields for buyers in the sought-after categories: apartments, grocery-anchored retail, warehouse, and 24- hour office. Consequently, interviewees are conflicted about
Emerging Trends Barometer: 2003 Rating on a 0-to-10 (poor-to-excellent) scale Suburban Community Warehouse Office Apartments Shopping Centers 6.3 BUY SELL BUY SELL BUY SELL 5.8 BUY SELL 5.6 56% 17% 40% 14% 39% 38% 37% 29%
Buy Sell Hold HOLD 27% HOLD 46% HOLD 23% HOLD 34%
Downtown Research and Full-Service Limited-Service Power Regional Office Development Hotels Hotels Centers Malls BUY SELL BUY SELL BUY SELL BUY SELL BUY SELL BUY SELL 32% 23% 28% 28% 26% 17% 15% 46% 12% 59% 11% 33%
HOLD 45% HOLD 44% HOLD 57% HOLD 39% HOLD 29% HOLD 56%
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BEST INVESTMENT BETS: 2003
3 Invest in fortress malls through REITs. Buy warehouses in major Regional shopping center REITs provide the only sure-fire transportation hubs. avenue for owning these top-tier retail meccas. Public 1 operating companies have effectively cornered the A mall market; economies of scale in the managing and leasing of These industrial properties are “a great defensive play.” these properties give the companies significant advantages Despite premium pricing today, they offer “the best risk- over private owners with smaller portfolios. adjusted returns.” Appreciation potential is more limited, but income returns flow and “values hold better than for any other property type.” Tenant appetite exists for both newer big-box distribution space and more traditional lower-ceiling storage facilities. “Warehouses will bounce back first in a recovery.” 4 Buy Double-B CMBS. Concentrate office investing in Their returns register in the high single digits, and they’re established 24-hour markets less volatile than REIT stocks while providing considerably more liquidity than private real estate. Diversified mortgage (downtown and subcity). 2 pools offer downside protection. Unless borrower delin- quency and default rates mushroom from low levels — an They’ll “continue to do better” than suburban markets. unlikely prospect — seasoned bonds also look like winners Buy buildings “without near-term leasing exposure,” for risk-adjusted returns. discounting anything with lease rollovers through 2003. “Once you have bodies in the buildings, you have decent performance locked in.” Returns “won’t be glamorous,” but certainly “solid” and “reliable.” Likewise, owners who hold onto these properties “will be fine.”
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Focus on diversified markets 5 with defense industries. The government’s ramped-up military spending could be a boon to areas like Southern California, the inside-the- Beltway suburbs of northern Virginia around Washington, Prune grocery-anchored retail. D.C., and Boston. 8 These centers have had a great run. Market-dominant No. 1 and No. 2 centers with established supermarket chain tenants are strong holds, especially at infill locations where Wal-Mart won’t be a threat. But pricing has turned “outrageous” as investors gravitate in droves to these Borrow. coupon clippers. Sell weaker strips and community centers 6 into the capital frenzy. Take advantage of the historically low interest rates while you can — to leverage up returns on stabilized assets or to prudently enhance properties. Most observers see rate hikes ahead — the time is now. But financing marginal properties today could create havoc if markets don’t recover soon enough and cash flows falter. 9 Sell quality assets. “It’s an absolute sellers’ market,” with ample, but disciplined, capital scrounging for any and all “stabilized” Hold apartments. investments. “If you have a good property, you’ll get top 7 dollar.” Market troughs don’t usually offer such oppor- tunities. A quandary arises: “Where do you reinvest the High pricing coupled with softened occupancies and rental proceeds?” Maybe it’s better to forgo the temptation. rates reduce the attractiveness of multifamily acquisitions temporarily. “There’s no pop.” But long-term market trends are extremely favorable.
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BEST INVESTMENT BETS: 2003 (CONTINUED) Opportunity Plays
Buy in the hot-’90s-tech-boom 10 markets that have gone cold. That’s if you can realize distressed pricing. Markets like Silicon Valley, Seattle, northern Virginia, and the Boston suburbs will rally eventually with tech industries’ inevitable rebound. Owners in San Consider B malls Francisco’s 24-hour office market are generally well selectively. capitalized and are wisely holding on — good value 12 deals will be hard to come by even though market occupancies and rents have plummeted. Caution reigns. “Your chances of going down are high.” Long-suffering owners shove product onto the market hoping the capital tide bites. Dominant malls in smaller markets and No. 2 malls in large markets are dicey tickets. While potentially offering “better relative value” than fortress centers or grocery-anchored retail, they Consider mezzanine debt “must have proven defensible and sustainable investments. trade areas or they’re quicksand.” Attractive 11 cash-on-cash returns range into the low to mid High-single-digit current returns with accrual teens without leverage. Exit strategies are always features are attractions. “You want at least 10%- a concern. “Your return may have to depend 15% equity in front of you." Avoid financing on amortization.” straight development projects — too risky. “There will be winners and losers.”
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Contrarian Moves Avoid...
Buy full-service Limited-service hotels. hotels. 15 13 Institutional investors show no interest — there Buy full-service hotels that cater to business are few barriers to entry and too many brands. travelers in 24-hour markets — mid-1990s pricing is back in some markets. “Underwrite off the 9/11 dip and get a premium,” betting that road warriors will finally get back into gear. “But don’t expect any great value deals.” 9-to-5 downtowns. Construction starts have dropped significantly 16 and operating costs are under control. Distressed “You can get the biggest property bargains sellers have been scarce — most owners are there — far below replacement cost. But who holding on as recovery beckons. September 11 wants to replace them?” fallout makes risk/return perceptions especially cloudy in this category.
Buy suburban office Development. 14 in 24-hour subcities. 17 “Let’s get vacancy rates down first!” Again — only if you can realize substantial discounts to replacement cost. This sector’s volatility makes for good opportunity investing at or near market bottom. If markets worsen during 2003, as expected, with rental rates And what about... slipping further and vacancies staying high, more owners may become “motivated sellers.” Assume some rollover risk and leverage up returns, taking advantage of reasonable Power centers? financing rates. But concentrate on better 18 buildings in stronger locations with at least some barriers to entry. These assets will recover “You either love ’em or hate ’em.” Buy or more quickly. Avoid B-quality (or lower) hold the best locations near top regional commodity product, especially buildings with malls. Make sure your tenant lineups are poor access and limited parking. the category killers, not also-rans. Buyer interest increases.
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CAPITAL FLOWS
Interviewer: “How do you explain y all accounts, more capital is finding its way into the real estate markets — there’s no shortage of the apparent increase in flow of Bsources. On the equity side, REITs and REIT mutual funds have attracted a flood of dollars from both funds to real estate?” institutional and individual investors. Pension funds are looking more seriously at upping real estate allocation targets, although that may be a drawn-out process. Foreign institutions — particularly German — have stepped up Emerging Trends Respondent: activity markedly. And an array of private syndicators are returning in force after a long absence, successfully raising “We’re the least worst asset money from individual investors.
class. We’re the least bad play, On the debt side, CMBS conduits and domestic banks remain the larger players, joined by the familiar life compared to bonds and the stock insurers, an increasing cadre of foreign bankers, and varied mezzanine debt lenders. market.” “Everyone has been pleased with real estate performance,” says a pension fund advisor. “It’s been the best-performing asset. Clients are so beat-up right now they’ll slap you on Interviewer: “Does that make you the back and congratulate you if you give them any return feel better about touting real that doesn’t show up in red or have brackets around it.” Debt investors expect delinquency and default rates to estate performance?” increase — from near-record lows — but express only modest concern. Better underwriting, more borrower equity in structures, and low interest rates should temper discomfort. Respondent: “Not really. It feels CMBS markets “have yet to be tested and may not be.” Ample capital has kept the markets liquid and lubricated sort of odd.” values even as vacancies have increased. But what happens when empty space actually starts to hurt cash flows? “The worst may be over for deteriorating fundamentals, but we could still feel more of the effects.” In fact, while most observers may have been correct in predicting 2002 would be the low point in this real estate cycle, “2003 may be the real test for the capital markets.”
Indeed, investors must wonder how money sources will react if, as anticipated, most property markets continue to slog through an uncomfortable performance trough,
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REAL ESTATE SHOULD RETAIN A SIGNIFICANT GROUP OF FOLLOWERS WHO CAN ATTEST WITH GREATER CONFIDENCE TO ITS VALUE IN DIVERSIFIED, MIXED-ASSET PORTFOLIOS.
EXHIBIT 3-1 retain a significant group of followers who can attest with Availability of Capital: 2003 greater confidence to its value in diversified, mixed-asset as of June 30, 2002 portfolios. That’s a major step forward for an investment category that has been scorned and discounted by many
Pension Funds 6.9 players since the early ’90s property market depression.
Life Insurance 6.5 Then again, “with a series of blow-ups, capital could Companies suddenly vanish.” That’s unlikely, but no one is confident Commercial Banks 6.2 enough to rule it out. At the very least, 2003 will gauge Entrepreneurial restored conviction. Capital 6.6 Equity REITs and private equity limited partnerships CMBS 6.7 dominated acquisition activity through 2002. Both groups Wall Street 6.2 benefited from capital infusions drawn from investors fleeing stocks. Pension funds were held back from new Foreign Investors 6.0 investing by the denominator effect — stock market losses
REITs 5.7 ratcheted down overall portfolio values, pushing real estate allocations above funds’ target levels by default. As a result, Overall 6.7 REITs, with a record $171 billion of market capitalization,
0 5 10 have increased their dominant equity ownership investment Decrease Stable Increase position with a 43% share, compared to $149 billion, or 37%, for pension funds. Foreign investors increased their Source: Emerging Trends in Real Estate 2003 interviews market position slightly to 12%, reaching their largest total value position ever — $47 billion. Insurance companies making the “least worst” look less attractive. Will fickle continue to be net sellers. Their market share — capital hang around? diminishing steadily since the early nineties — is now down to only 8%, or $32 billion. Emerging Trends interviewees suggest that capital sources will remain fully engaged in the property markets. See Overall, total equity has increased from $223 billion in Exhibit 3-1. They contend that real estate is proving it can 1992 to a current value of $403 billion. deliver superior risk-adjusted performance through an Debt Commercial banks and CMBS issuers remain entire market cycle. Returns have dropped into the single kingpins in the debt origination markets. Banks continue to digits, and there has been some depreciation, but income make more loans and hold a considerably larger market share, remains relatively strong and performance has stayed but CMBS wield more influence in disciplining the market positive. Long-term leases — especially in office and retail and setting lending parameters. Banks hold onto a 42% share — protect cash flows through rough markets. Investors’ of invested debt capital, while CMBS issuers increase slightly overall yield expectations, meanwhile, have been reset to 17%. Life insurers’ share declines marginally, to 12%, and downward in light of the stock market’s volatility and foreign investors edge up to about 12%. uncertainty, as well as low inflation and low interest rates. “Real estate looks good.” Institutional debt has nearly doubled since 1992 — now totaling almost $1.85 trillion. No doubt a revived stock market would shift investors’ attention back toward Wall Street. But real estate should
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EXHIBIT 3-2 Institutional Capital Sources As of September 20, 2002
Non-institutional: $2.39 Trillion*
TOTAL U.S. REAL ESTATE: $4.63 TRILLION Institutional: $2.24 Trillion
Savings Associations $0.9B - 0.2% Commercial Banks $2.5B - 0.6% REITs Life Insurance Companies $171.2B - 42.5% $32.4B - 8.0% Total Equity: $402.8 Billion Foreign Investors $47.1B - 11.6%
Pension Funds $148.7B - 36.9%
Savings Associations Federally Funded Mortgage Pools $142.0B - 7.7% $86.6B - 4.7% Foreign Investors Other $48.6B - 2.6% Total Debt: $1,841.4 Billion $213.6B - 11.6% Pension Funds Life Insurance Companies $41.4B - 2.2% $226.4B - 12.3% REITs Non-Government CMBS Issuers $9.0B - 0.5% $307.5B - 16.7% Commercial Banks $766.3B - 42.0%
* Includes $445 billion of private equity (partnerships, Sources: Rosen Consulting Group, syndications, individuals, and family trusts) Lend Lease Real Estate Investments
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“THEY DON’T THINK IN TERMS OF ASSET ALLOCATION MODELS; THEY JUST THINK REAL ESTATE IS A BETTER ALTERNATIVE THAN STOCKS.”
Capital Trends: REITs Real estate investment trusts and mutual funds corralled a Equity ton of flight capital in the first part of 2002. “REITs’ stock The Return of Limited Partnerships pricing has been functioning counter-cyclically to the overall stock market.” Their dividend yields are extremely Private limited partnerships, sponsored by a diverse mix of attractive and their income orientation is manna for local syndicators, have renewed their investment presence, investors scorched by plunging stock prices and “looking making inroads in markets once the province of insti- for security.” tutional investors. Some estimates suggest that private REITs have been trading at or near asset values, but have investment funds now account for more than a quarter of not been immune to weak market fundamentals. Dividends all commercial acquisitions over $5 million in size. appear relatively secure. “Through mid-2003, income Typically, the transactions are under $20 million and are security may be stretched,” says a REIT portfolio manager. focused on smaller bites: apartments, grocery retail, and “It will be a sloppy time [for returns and capital flows], but suburban office. “Institutional capital markets have not prospects should improve once the economy emerges and fully grasped the shift of private equity capital,” says an jobs get created.” REITs should be on the front end of any interviewee. “Private equity markets have witnessed a upswing. compression in yields. They don’t think in terms of asset allocation models; they just think real estate is a better Bolstered by secondary offerings and using large bank lines alternative than stocks.” of credit, REITs are active purchasers again. “They’ve become agglomerators,” focused on accumulating Observers wonder if some of these partnerships aren’t properties with sustainable cash flows. By holding properties overpaying for current yield on weaker properties, and in massive portfolios, REITs help keep property-market ignoring implications for exit returns. “They’re driving down transaction volumes down, maintain scarcity, and cap rates and making some questionable deals,” says a pension adviser. “These guys haven’t figured out risk or strategy,” another interviewee adds. “They’re making long-term bets on more fringe-type deals, some in secondary cities.” EXHIBIT 3-4 Equity Real Estate Performance vs. REITs EXHIBIT 3-3 TOTAL NCREIF Acquisitions by Private Investors 40% WILSHIRE REIT INDEX 30% $10B 8.1 20% $8B 6.2 10% 5.7 5.8 5.7 5.9 $6B 4.9 5.0 0% $4B -10% $2B -20% $0B ’92 ’94 ’96 ’98 ’00 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q ’02 ‘00 ‘00 ‘01 ‘01 ‘01 ‘01 ‘02 ’02 Sources: National Council of Real Estate Investment Fiduciaries, Source: Real Capital Analytics, Inc. Wilshire Associates, Rosen Consulting Group
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EXHIBIT 3-5 Real Estate Capital Flows
Equity
$200B
REITs
$150B Pension Funds
$100B
$50B Foreign Investors Life Insurance Companies
$0 Commercial Banks ’88 ’89’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 01 2Q ’02
Debt
$800B Commercial Banks $700B
$600B
$500B
$400B
$300B Non-Government CMBS Life Insurance Companies $200B Foreign Investors Savings Associations $100B Federally Funded Mortgages Pension Funds $0 ’88 ’89’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 01 2Q ’02
Sources: Money Market Directory, National Association of Real Estate Investment Trusts, Federal Deposit Insurance Corporation, American Council of Life Insurers, Bureau of Economic Analysis, Federal Reserve, Lend Lease Real Estate Investments, Rosen Consulting Group
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STARVED FOR NEW INVESTMENT OPPORTUNITIES BACK HOME, FOREIGNERS ARE ATTRACTED BY THE WORLD’S “RICHEST, LARGEST, MOST STABLE MARKET.”
lower cap rates, ultimately increasing market stability. The Pension Funds mall sector and major downtown office markets have been primary beneficiaries. Plan sponsors face tough sledding. Thanks to the bear market, total portfolio values have fallen dramatically just The larger, single-property-sector REIT companies enamor as liabilities associated with retiring baby boomers are set most interviewees. They appear to have “sophisticated” to increase in coming years. Companies that were using management teams “who really know what they’re doing” prodigious pension gains to pad profit statements only a and “add value” on the asset level, benefiting from scale and few years ago now are inadequately financed to meet expertise. Corporate governance concerns shouldn’t become looming retiree payouts. a major issue for REIT companies. These businesses don’t require convoluted accounting or complicated tax Fund investment officers need to reevaluate their capital structures, and internal management aligns interests with strategies — overall portfolio losses may delay fulfillment shareholders. of commitments to increase investments in real estate, and the denominator effect will continue to influence decisions. Smaller REITs remain disadvantaged. Their cost structures The good news is that funds “aren’t worried about the for meeting securities’ regulations and dealing with share- overallocations, since real estate has been performing holders are higher and they offer no scale benefits to drive relatively well.” The bad news is they’re in no hurry to earnings growth. Institutional investors will privatize some raise allocations further. smaller companies, and consolidations with bigger REITs will continue. Small apartment companies are special Most pension boards won’t make hard decisions until the targets — pension funds can acquire a large portfolio of dust settles from stock market losses, but interviewees expect these coveted but difficult-to-assemble investments in one real estate targets to increase modestly. Real estate’s cash- transaction. flowing profile aligns well with pension funds’ growing need to pay out liabilities. The percentage of pension assets invested in real estate has crept over the 3% mark for the first EXHIBIT 3-6 Pension Fund Assets in Equity Real Estate time since 1996 (the record high was 4.5% in 1990). Larger public funds typically allocate more than smaller funds or TOTAL PENSION ASSETS (left scale) PERCENT OF PENSION FUND ASSETS IN corporate plans, and are more likely to go as high as 10%. EQUITY REAL ESTATE* (right scale) Skittishness about putting dollars out at market bottom has $8,000B 5.0% also restrained sponsors. “They don’t want to get into another $7,000B 4.0% trap.” Core players increasingly look to REITs for perceived $6,000B greater liquidity and fewer of the hassles associated with direct $5,000B 3.0% investments. Funds’ interest in mortgage investments is slowly $4,000B expanding — particularly in CMBS, where they see good $3,000B 2.0% yield opportunities even in unrated bonds. But they remain small players in the real estate debt markets. $2,000B 1.0% $1,000B Money managers still struggle to develop defined- $0 0% contribution products that invest in private real estate. ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 Liquidity and daily market valuation are the stumbling points.
* Includes Pension Funds’ REIT investments Sources: Standard & Poor’s, Rosen Consulting Group
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EXHIBIT 3-7 pendulum may swing back, and some companies may take Foreign Investment in U.S. Real Estate another look at direct property investments after recent as of December 31, 2001 losses in other asset classes.” Never say never. Asia ex. Japan 6.4% Canada 14.2% Japan Wall Street 25.1% Germany 12.0% Middle East Investment bank opportunity funds wither on the sidelines 2.2% Netherlands Africa 10.5% as deals are few and far between and return expectations 1.4% United Kingdom diminish. Track records of maturing funds have been South America 6.7% compromised by the market downturn. “The opportunity 15.3% Other Europe 7.2% model looks dead.” Still, market dislocation may present Sources: Survey of Current Business, Dept. of Commerce, some opportunities for funds that have been holding their Bureau of Economic Analysis, Rosen Consulting Group powder. Expect some Wall Street firms to sponsor core funds or try to buy advisors with core funds. “God bless them, they’ll go where the money is every time.” “If you can create a vehicle with 7%-8% income-oriented return and low beta, you’ll have all the money you want.” Meanwhile, sponsors of 401(k) plans, spurred by rising Capital Trends: employee interest, latch onto REIT mutual fund options. Debt Foreign Investors Interviewees confirm that lenders have been “careful” and German investors return in force (new regulations allow “conservative” despite having poured $328 billion into the German mutual funds and mortgage banks to invest more real estate markets since 2000. “You don’t see lenders doing overseas) and Australian trusts increase their forays. Middle bad deals,” insists a mortgage broker. Eastern capital edges quietly back into U.S. markets after The widespread availability of market data and loan withdrawing in the 9/11 storm. Offshore investors have been information keeps mortgage officers and their bosses “particularly aggressive” at bidding up prime office prices in focused on market realities. It’s not easy to ignore danger 24-hour downtowns, and can often take advantage of lower- signs — rising office vacancies, lowered hotel RevPAR cost capital, more favorable exchange rates, and lower yield projections, rejected loan structures from CMBS offerings, expectations to muscle out U.S. players. Starved for new troubled projects in certain markets — when facts and investment opportunities back home, foreigners are attracted figures are pushed in your face every day over the Internet. by the world’s “richest, largest, most stable market.” Construction lending is limited and controlled, especially Life Insurance Companies for bigger projects where a handful of banks syndicate deals to one another and hold a tight check on underwriting. Life insurers continue their decade-long sellout of equity Office loans are loaded with recourse and stiff preleasing portfolios, abandoning a market they once dominated. requirements (50% is typical), while loans for large new Many insurers have dismantled their real estate arms, as hotels are virtually impossible to attain. Regional banks have accounting disadvantages and risk-based capital require- been less strict about the under-$20-million deals — mostly ments make direct property investments onerous. “The apartments and strip retail. But project activity should slow further into 2003 — developers can hardly expect friendly
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MOST CMBS DELINQUENCIES WILL SHOW UP IN SECURITIES THAT WERE “PUSHED THROUGH THE SAUSAGE GRINDER” IN THE HARD-CHARGING 1996-98 PERIOD.
receptions from bankers in softened markets. Indeed, five years ago — the art of the deal was buying the best continuing lender discipline on construction financing will credit deals anywhere. Now you need to figure out where be essential if markets are to recover more quickly. the relative value is up and down the yield curve.”
Now near rock-bottom levels, problem loan rates can only Strong investor interest has made the market extremely increase. If pushed, interviewees predict delinquencies could liquid. “If you’re lukewarm about any of your bonds, it’s a top out at 3% — manageable compared to the 8% peak good time to sell,” says an advisor. Most CMBS delin- resulting from the early-’90s tailspin. “Delinquency of 2% quencies will show up in securities that were “pushed on average is pretty comfortable under any circumstances.” through the sausage grinder” in the hard-charging 1996-98 period preceding the temporary debt market collapse in the fall of ’98. That’s when offerings were loaded with “weaker CMBS credit deals, limited-service hotels, assisted-living facilities” and more fringe properties (and before the B-piece cartel Commercial mortgage-backed securities managers complain gained ascendancy). New-issue bonds, in contrast, have that their business has become “boring,” “grind-it-out “not been loaded up.” Offerings comprise a range of “top- work.” “There’s not a lot of sex appeal anymore.” “We’re a of-the-pyramid” loans on multifamily, grocery retail, malls, mature industry now.” But in the sober world of the bond and multitenant office with low rollover risk. Lenders stay markets, that means “we have arrived.” Investor interest is away, in particular, from “single-tenant anything.” materially higher — a “groundswell” enticed by attractive yields, credit fundamentals that compare favorably to The B-piece cartel — a small group of highly disciplined corporate bonds, and, now, published data on trailing one-, bond buyers who make sure all offerings pass muster — is three-, and five-year returns that institutional investors can “stronger than ever.” Their scrutiny of deals “drives the get comfortable about. whole process,” dictating how offerings are structured and which loans are included. Bankers and insurers, who want This more-seasoned market results in reduced value spreads the flexibility of securitizing their whole-loan portfolios in between CMBS and corporate bonds. “In the old days — the future, toe the B-piece cartel’s line in their own under- EXHIBIT 3-8 writing. Discipline has been driven through the entire CMBS Market commercial lending system by the private market’s “self-
Volume Total Market Capitalization protecting” review process. Rating agency scrutiny of bond $100B Issuance (left scale) $350B issues adds another layer of oversight. CMBS Cap (right scale) $300B Offerings may tail off in early 2003, as investors pull back to $80B digest fallout from the expected surge of problem loans. $250B “Brakes will come on as delinquencies go up.” But later in the $60B $200B year could be a good time to buy into the recovery. On average, issuance should continue its billion-dollar-a-week clip. $150B $40B $100B While special-servicer activity is expected to increase as $20B defaults rise, interviewees are confident that most bonds will $50B weather the period. Investment-grade investors look safe: $0B $0B “There’s 40% equity that you’d have to burn through, given ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 2Q typical loan-to-values on individual mortgages,” and pools ‘02 Sources: Federal Reserve, Commercial Mortgage Alert, are well diversified. B-piece buyers are more exposed, but Rosen Consulting Group “they’ve been well compensated in yield for the risk they
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have assumed.” Larger single-asset CMBS “can get very lower yield expectations in their home markets. Everybody tricky” and some individual deals could go sour. But in all, is watching to see whether these offshore lenders will get the interviewees do not expect the market to be stressed. ahead of themselves. If markets deteriorate too much they “We’ve made it through,” says an investment manager. That could become a loose cannon. But not yet. may be a bit premature, but the signs look positive. Mezzanine Lenders Banks and Life Insurers As mainstream lenders maintain some restraint, a host of Domestic bankers continue to dominate the recourse mezzanine debt funds offer borrowers some relief on equity whole-loan markets, looking to securitize loan pools where requirements and provide another alternative for raising possible. Life insurers remain important players too, but capital. “A lot of money is chasing a limited number of increasingly rely on CMBS to satisfy their investment deals,” forcing yields down. “It’s unrealistic to get returns appetites. Bigger deals are typically syndicated. “Everyone is above 15%; the low teens are more viable.” Mezz funds have looking to lay off risk and have exits. They want portfolio paid top dollar, especially on development deals, anticipating liquidity and the ability to sell off their paper quickly if that rents and occupancies would go up. “It hasn’t happened they need to.” Managing balance sheet exposure and — there are some silent workouts going on.” Opportunities avoiding portfolio meltdowns are paramount issues for exist on more stabilized properties, especially multifamily in these institutions, which remain haunted by severe losses a markets that are showing some softness. decade ago. This guarded approach braces the lending markets with an additional layer of self-restraint. EXHIBIT 3-9
Most of the time, the self-imposed liquidity requirements Life Insurance Company Delinquency and force bankers and insurers into following the underwriting In-Foreclosure Rates strictures established by the CMBS markets. But insurers 10% DELINQUENCY RATES will make exceptions and loosen loan-to-values from 60% IN-FORECLOSURE RATES ceilings up to 75% on “the really good stuff” from prime 8% borrowers, who want to avoid restrictions placed on them by CMBS lenders and are willing to pay for it. Insurers can 6% find good relative value between their CMBS investments and whole loans, and it gives them options for deploying 4% money more effectively.
2% Foreign Banks 0% ‘80 ‘82 ‘84 ‘86 ‘88 ‘90 ‘92 ‘94 ‘96 ‘98 ‘00 2Q In major markets, European banks — primarily German ’02 — are giving U.S. bankers a literal “run for their money,” Source: American Council of Life Insurers beating them on pricing, capacity for doing multiple deals, structures, and the ability to principal (take down the whole loan without syndication). “In many larger deals foreign banks are blowing the domestic guys away.” Their aggressive practices look “relatively prudent,” given the
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MARKETS TO WATCH
From east to west, enthusiasm for ess worse” markets like Miami and Philadelphia rise in the ranking because U.S. real estate markets is on the “Lothers are more distressed. “Hot-growth” towns are the losers. Houston’s impressive comeback wane. For 2003, only Washington, stalled out suddenly in the Enron carnage. Denver hit D.C., New York City, and the the skids on the back of a telecom meltdown. Atlanta and Dallas — everyone’s favorite whipping boys when massive Southern California the going gets tough — overbuilt again and are paying the price, with job growth evaporating. agglomeration (San Diego to On the Emerging Trends metro area risk/return diagram, north of Los Angeles) retain all markets except Washington, D.C., slide into less comfortable zones for 2003, mostly deeper into the investor loyalty — with caveats. higher-risk/lower-return quadrant. See Exhibit 4-1. Chicago and Boston weaken, but These modest shifts from our 2002 report suggest that markets will be bottoming out in the year’s “choppy” are buoyed by their 24-hour economic climate. status and more diversified Urban Stress Increases economies. San Francisco — a Last year’s forecast accurately reported that the nation’s perennial survey leader because Big Six 24-hour cities “had peaked,” faced with of enduring round-the-clock challenges ranging from a souring economy, federal indifference, and failing public schools to, possibly, a characteristics — maintains a big-city “fear factor” following the terrorist attacks. The fear factor abated quickly. In fact, wounded Washington respectable ranking despite its and New York retain top survey rankings this year (though switching positions). But other serious urban market crash. Traditionally, these hurdles definitely remain.
markets hold value better in Economic Fallout A sullen economy is taking its bad times and show greater toll, shrinking tax revenues and inflating budget deficits at both local and state levels. States with 2002 gubernatorial appreciation in the good. Again, elections — like New York and California — will delay the bad news and suffering until after the November this year, interviewees give them voting. But the handwriting is on the wall. Expect impacts in 2003 and 2004, after all rainy day reserves and the best odds for weathering the accounting tricks have been exhausted. Government market trough. layoffs and service cutbacks will occur and capital projects will be mothballed.
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“THE MAJOR CITIES WILL BE THERE FOREVER,” INSIST THE INTERVIEWEES.
EXHIBIT 4-1 Metro Areas – Return and Risk: 2003
Washington, D.C. New York
San Diego Los Angeles Chicago Boston Miami
San Francisco Seattle Return Philadelphia
Minneapolis Houston Phoenix St. Louis Dallas Denver Detroit Atlanta
Risk
Source for all exhibits in Chapter 4: Emerging Trends in Real Estate 2003 interviews
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Crime and Trash A mayor’s demographic trends — an influx of but not even the World Trade Center chief concerns are keeping crime young singles and empty-nest baby destruction could knock the city “with down and streets clean. If murder boomers — as well as by economic some of just about everything” too far and theft rates increase in prime windfalls. But Generation Y will be off stride. Southern California markets neighborhoods and tourist hot spots, marrying and raising families over derive enormous benefit from what is today’s 24-hour meccas could quickly the next decade. Without good probably the nation’s broadest regional revert to the scarier environments of schools the migration from down- economy — ranging from movie- not too long ago. Dirty sidewalks and towns to suburban cul-de-sacs could making to aerospace and biotech. parks, likewise, symbolize decline and regain steam. Big cities scramble to Likewise, Boston and Chicago profit decay. The dynamism and heady aura find a solution before it’s too late. from their substantial arrays of of city life, restored during the ’90s industry and business. Even Miami But “the major cities will be there bubble, will be tested in the next few and Philadelphia gain favor in this forever,” insist the interviewees. A years and could evaporate quickly year’s survey because of more compelling mix of big business, unless business and job growth diversified and balanced local power, culture, entertainment, resume in earnest, filling tax coffers economies. A shallow downturn, like amenities and, most importantly, fine and keeping people employed (and the recent recession, won’t throw any residential neighborhoods draws not out of trouble). A recent increase in of these cities for an extended loop. only people but also their money, the nation’s poverty rate is an which, in turn, provides “greater Recent experience also demonstrates unsettling sign. liquidity” — witness the recent flood how less-diversified market Not the Fed’s Priorities of capital into choice product in top economies can turn fragile when key Today’s federal government is in no 24-hour business districts. The industries ebb. Seattle (high-tech, position to give cities a hand, even if unique scale and social fabric of these aerospace), Denver (telecom), and it wanted to. A one-two punch of singular places ward off many of the Houston (energy) are poster children lower tax receipts and Bush tax cuts vicissitudes that have cratered lesser for what happens when markets rely pushes urban-agenda items like urban centers. At least for now. too heavily on a particular industry. housing assistance, mass trans- But even a 24-hour city like San portation aid, poverty programs, and Business Francisco can be stopped in its school funding back even further on tracks. The Bay Area’s creeping the political priority list. With Diversification dependence on high-tech businesses stepped-up defense initiatives taking Provides Essential over the past decade was somehow an increasing share of what’s available, Cushion overlooked amid dot.com mania. cities get left out in the cold. Now, everyone realizes that San Francisco is less diversified, more Unquestionably, the business School Failures Education vulnerable, and more volatile than diversification of 24-hour cities remains the most corrosive longer- other 24-hour stalwarts. term urban issue. Without sound bolsters them in rough economic school systems, middle-class families times, while markets dependent on Holding Back Development leave, poverty proliferates, and industry clusters are likely to falter. Barriers to entry also continue to neighborhoods decline. Businesses Washington, D.C., has big govern- separate the more-favored 24-hour join the exodus and tax rolls ment to cushion the impacts of high- markets from weaker ones. This real dwindle. The downward spiral was tech declines in its suburbs. New estate bromide bears repeating arrested in the ’90s by favorable York totters when Wall Street shakes, particularly when excessive
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NOT ONLY ARE MANY SUBURBS “NOT COOL ANYMORE,” THEY ALSO “DON’T WORK” VERY WELL.
development magnifies Banal commercial strips and zealous development and severe disequilibrium in suburban gasoline alleys (“if you’ve seen one, droughts. Americans — whether agglomerations. Not surprisingly, you’ve seen them all”) they live in the Arizona desert, on Houston, Denver, Phoenix, Atlanta, Long Island, or in the shadow of the Regional infighting and ruinous and Dallas receive lower marks in competition for tax base among snow-capped Rockies — are waking this year’s survey because of lax local governments up to the reality that water is a controls on new construction in limited resource. In coming years The demise of older, less their wider-open spaces — which water scarcity will make development strategically located regional malls translates into higher vacancies and more expensive, or in some areas lower rents. No question, developers Poorly aging housing stock in impossible — especially parched would love to build more in the 24- inner-ring suburbs (which regions of the Southwest and West hour cities too. But site scarcity, increasingly look like some (including Southern California). But geographical boundaries (lakes, inner-city neighborhoods) even normally rain-nourished places rivers, oceans, and mountains), and As sprawl proceeds and families confront uncomfortable, possibly more zoning/environmental stream into new subdivisions, these permanent, shortages. Atlanta’s impediments severely restrict their issues become more severe. Except diminishing watershed threatens a production. The result, over time, is within urbanizing subcity nodes and three-state region served by the healthier markets with better better infill locations, suburban Apalachicola-Chattahoochee-Flint investment performance. properties are hostage to random river system. Water districts face a development pressures, becoming supply crisis in fast-growing areas little more than commodity around Charlotte and Raleigh in Suburban Woes Redux investments over time. Increasingly, North Carolina. Florida deals with local governments and developers saltwater encroachment on depleted Familiar problems — catalogued realize “they must create enduring freshwater aquifers. And New York in past Emerging Trends — persist main streets and real places” which at City contends with protecting its in many suburban markets, least mimic 24-hour environments. reservoir system from leaking septic contributing to less-satisfying Not only are many suburbs “not cool systems, road runoff, and other lifestyles and potentially more anymore,” they also “don’t work” pollution sources. compromised environments for very well. businesses and property owners. Today’s restrictions on watering lawns They include: and washing cars could become Looming Water Crisis tomorrow’s ban on new subdivisions Traffic congestion and car or office parks, closing of resort golf dependency (pedestrians are Last year’s Emerging Trends courses, and uncomfortably high an endangered species) highlighted how water or the lack of sewer and water taxes. Already, Lack of planning that would it would become an increasingly designer bottled water costs more integrate retail, office, and critical issue for many regions. That’s than gasoline. What happens when residential districts (adjacent happening already, whether taps really run dry? subdivisions and shopping attributable to global warming or centers aren’t connected) not. In many areas, reservoirs and
Stressed infrastructures (roads water tables have been lowered to and sewers) dangerous levels by a combination of
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EXHIBIT 4-2 phenomenal.” K Street is ground Markets to Watch Top Tier Sags zero for core investors’ strategy of INVESTMENT acquiring high-occupancy buildings DEVELOPMENT Washington, D.C. with low rates of pending turnover, adding some leverage on a 7%-8% 6.7 Washington, D.C. 5.5 yield, and sitting back on a secure 6.6 Always a relatively “recession-proof” New York 5.2 bond-plus return. Foreign buyers “island of security,” the nation’s Los Angeles 6.3 with lower yield expectations have 5.1 capital regains top spot in the survey San Diego 6.3 been particularly active, drawn to the 5.1 for the first time since 1995, when, 5.9 familiar world political center. But Chicago 4.3 maybe not so coincidentally, 5.8 some interviewees recoil — the Boston 4.1 commercial real estate was emerging market is “crazy,” “just too pricey,” Miami 5.6 from its last cyclical low. “D.C. is the 4.4 and “not a good risk-adjusted San Francisco 5.3 only first-tier market in the country 3.7 return.” Outside the Beltway, 5.0 right now — that’s it.” No matter Seattle 3.8 northern Virginia suburbs have 4.9 whether Republicans or Democrats Philadelphia 3.8 suffered in the telecom/high-tech 4.8 control the power corridors, Portland 3.9 blowout — WorldCom’s debacle hit government keeps leasing space and Minneapolis 4.7 hard in the outlying Dulles/Herndon 3.7 lobbyists seem to multiply. But rents Tampa 4.7 and Tysons Corner markets. 3.8 have slipped slightly off 2000 highs, 4.6 Anticipated cushioning from Baltimore 3.7 and law firms (30% of downtown 4.5 increased defense spending hasn’t Houston 3.5 tenancy) have started subleasing panned out yet, but should San Jose 4.5 space. Buyers swarm into the 3.1 materialize in 2003, helping to start 4.4 District’s office market, bidding Las Vegas 3.8 recovery. Hopes rest on Pentagon 4.4 everything up to replacement cost — Phoenix 3.4 handouts. Who says big, bureau- 4.4 “even some tech-wreck buildings.” Denver 2.8 cratic government is all bad? 4.3 “Not all the girls at this dance are Atlanta 3.0 pretty, but someone’s going to ask Orlando 4.3 3.5 them out — the interest has been 4.2 Charlotte 3.2 New York Dallas 4.2 2.9 8 4.1 St. Louis 3.4 “Price per pound” increases on prime 7 6.7 4.0 Austin 2.9 office, and cap rates fall as buyers 4.0 6 pounce on well-leased Midtown Nashville 3.4 4.0 buildings put on the block. Concern San Antonio 3.3 5 rises about further contraction in the Detroit 3.9 Washington, D.C. 3.2 4 backbone financial industry, and city Indianapolis 3.9 3.2 3 services get hacked to close a Cleveland 3.6 2.9 widening city budget deficit. 3.6 2 Columbus 2.9 Vacancy increases and rent declines 0 10 1 have been modest — no upward Poor Excellent 0 pressure on rates is expected before '93 '95 '97 '99 '01 '03 2004. Limited office development is
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THE APPLE’S ENDURING “BRAVURA” HELPS OVERCOME THE 9/11 CATASTROPHE IN LOWER MANHATTAN.
cultural amenities, and transpor- country. After more than a decade, 8 tation links. That result could be the some buyers gamble on downtown Los 7 greatest, most lasting monument to Angeles, snagging “bargain” class A 6 6.6 the almost 3,000 lost in the World office at 60% of replacement cost. Trade Center’s collapse. “They figure it has to get better some 5 time.” However, skepticism lingers 4 over the lack of residential space and 3 Southern California congestion problems affecting commuters from outlying prime 2 New York neighborhoods — “Downtown Los This mega suburban agglomeration 1 Angeles didn’t recover in the last big features the nation’s “best multifamily economic recovery. Why should it 0 markets” and “great” warehouse '93 '95 '97 '99 '01 '03 turn around next time?” Office centers. Considerable business markets weaken across the board — diversity — defense, entertainment, good news. “The market is extremely west Los Angeles and northern San biotech, financial services, Port of Los viable, with diversity and high Diego (a former dot.com haven) Angeles — has moderated recession barriers to entry.” Still, “the bloom is struggle harder. Century City, impacts. The ocean, mountains, and off the rose.” The luxury co-op/ Irvine/Orange County Airport, and desert finally pinch sprawl. Develop- condo market softens after a La Jolla look relatively strong. Long- ment restraints (Proposition 13 prodigious run — new product is term prospects improve for tax/spend limits) and investors’ flight poorly timed. Wall Street bonuses downtown San Diego office, with to quality have combined to push up aren’t what they used to be. Overall, new stadium and residential prices “uncomfortably” — especially the “always tight” rental apartment development creating a more on “chronically undersupplied” market stabilizes after a brief dip. attractive, multidimensional urban apartments, which many investors Hotels also show surprising environment. resilience. Suburban office looks call “bulletproof.” In general, cap more vulnerable, tracking national rates for all property types “persistently and structurally are trends. The northern New Jersey Chicago warehouse/distribution hub, which lower” than in other parts of the serves the entire Northeast, remains a favorite investor magnet. The Apple’s Interviewees generally agree that 8 enduring “bravura” helps overcome Chicago is “a good solid market” and the 9/11 catastrophe in lower 7 “the place to be in the Midwest.” But 6.3 Manhattan. How much new office 6 2003 will be a bottoming year. As in space gets built in the looming other 24-hour cities, supply/demand 5 downtown redevelopment will shape fundamentals deteriorate, with room the city’s markets for generations to 4 for pricing to follow if capital pulls come. City powerbrokers have a 3 back. “You need to be leery — it’s compelling opportunity to complete Los Angeles one of the few markets where too 2 the financial district’s transformation much new space is being delivered.” into a dynamic 24-hour neighbor- 1 San Diego While Boeing has come to town, the loss of Arthur Andersen, plus hood, expanding its residential 0 components as well as adding parks, '93 '95 '97 '99 '01 '03 problems at United Airlines and
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will be “moribund” — softened 8 Chicago markets and widespread antigrowth Lukewarm to
7 sentiment frustrate developers. The high-tech Route 128 corridor takes its “Less Worse” 6 5.9 lumps. Financial services, health care, 5 technology, and education “cycle Miami
4 independently” and underpin a multifaceted economy. Local colleges 3 As other cities drop in the survey, and universities provide a never- Miami reaches its highest ranking in 2 ending supply of high-quality years. South Florida has built out — intellectual capital to fuel businesses. 1 the ocean and Everglades crimp new Eventual completion of the Big Dig 0 development, and urban centers benefit '93 '95 '97 '99 '01 '03 can only enhance the financial district from “a move back East.” A diversified and waterfront. Anything is better mix of smaller office tenants — than struggling with its construction domestic and foreign banks, law and Motorola, raise concerns. In the hassles and navigating its unsightly accounting firms, and trade consultants Loop, stay away from class B office work sites. Apartment pricing soars to — dominate the Brickell and space with any vacancy or near-term “irrational” levels — “time to back downtown markets. “A major employer lease expirations. Overall, off.” Hotels have been hard hit — blowout hasn’t dinged the market.” development opportunities are new product near the convention Suburban office deteriorates — like currently “next to nonexistent.” center and luxury properties have everywhere else. The luxury hotel Distressed selling has begun in suffered more since 9/11. market drowns in new projects — suburban office markets — “there’s a “developers weren’t watching the growing recognition the future isn’t pipeline.” Retail always does well, but 8 getting brighter.” Downtown condos Wal-Mart threatens second-tier, grocery- are overbuilt and warehouses are 7 anchored retail centers. Ultimately, the overpriced — too much capital 6 better the Latin American economies chasing quality product in this key 5.8 do, the better this gateway performs. national distribution hub. Hotels sag. 5 Boston “Any improvement will be slow and 4 steady — the very definition of the 8 3 Chicago market.” 7 2 6 5.6 1 Boston 5 0 '93 '95 '97 '99 '01 '03 4 Beantown should stabilize in 2003. Office rents could edge up in 2004, 3 but “expect no massive recovery.” 2
Scarcity of prime product in a 1 Miami constricted downtown market keeps 0 prices relatively high. Development '93 '95 '97 '99 '01 '03
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“ONCE HIGH-TECH REVIVES, THE BAY AREA GROWTH ENGINE WILL RESTART.”
San Francisco Most investors would buy here in diversification.” East-side markets like a New York minute if office or Bellevue were more vulnerable to the hotel owners should appear bubble collapse and telecom blow-up No tenant demand, worst distressed and put up for-sale than downtown, which increasingly fundamentals since the late ’80s, signs. Institutional and REIT “looks like a 24-hour city.” Recent and sinking office rents — a owners aren’t going anywhere — residential development has helped depressing combination. A return lowered office rents have dropped downtown neighborhoods develop to equilibrium and rent growth from unrealistic 2000 spikes, and expand, and increasing suburban may be “three to five years out.” leveling off at 1997 rates (down traffic congestion should keep demand Hotels stagger with the slackening certainly, but not a disaster). high for close-in housing. Look for of business travel to the former Class A office buildings without some good short-term buying (and, so far, the only) world capital short-term rollover risk are opportunities in apartments. Kent keepers — they’ll ride through Valley industrials also hold their own. the trough. Avoid most suburban and class B office. Barriers to 8 8 entry and high development costs 7 7 put the possibility of new 6 construction in the deep freeze, 6 aiding recovery prospects. Once 5 5 5.3 high-tech revives, the Bay Area 5.0 San Francisco 4 Seattle 4 growth engine will restart. In 3 hindsight, the market’s 3 overreliance on the tech world, 2 2 which stands in contrast to 1 1 Southern California’s stable, more diversified economy, has rendered 0 0 '93 '95 '97 '99 '01 '03 '93 '95 '97 '99 '01 '03 the market more volatile than other 24-hour cities.
of the New Economy. To the Philadelphia south, Silicon Valley R&D is Seattle “bloody.” Rising insurance costs (earthquake, not terror) cause This market meanders into the further discomfort. But the worst Again, this Pacific Northwest city Emerging Trends top 10 for the first appears over — “the downward stands in San Francisco’s shadow time ever, largely by default. Philly slope has flattened” and the long- and follows its lead — “ditto the escaped tech/telecom exposure and term desirability of this perennial San Francisco office story.” How- has a diversified economic base — 24-hour powerhouse “hasn’t ever, Seattle’s recovery should lag insurance, banks, pharmaceuticals — changed.” “It has all the elements behind the Bay Area’s. Microsoft, which benefits from a lower cost of you need.” The residential market other high-tech companies, and living and doing business than in has been “incredibly strong,” Boeing drive the local economy, neighboring Northeast cities. The bucked up by low interest rates. which “needs greater
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perpetually lackluster downtown Houston office market holds its own (rents “Challenged” have barely budged), but the suburbs “look rocky.” Expect leasing to be Minneapolis Before the Enron fiasco, downtown “lethargic” in 2003 and don’t look Houston was on the comeback trail for rent growth until 2004. “Tenants after nearly 15 years of see-through Survival of baseball’s Twins is assured need to burn through sublease space buildings and surrounding sprawl. for another four years — and it may first.” Apartments and retail appear Now vacancy could mushroom — take that long for the Twin Cities’ healthy. Center City historic sites, new projects are coming on line as downtown and suburban office growth generators are cut off. Energy 8 markets to recover. A Texas-styled companies are reeling. A new development binge combined with a basketball arena, light rail system, 7 stolid business climate equals trouble and high-rise apartment develop- 6 under the best of circumstances. Add ment had promised to bolster
5 downtown for the future. “Pulling 4.9 back inside the loop had been 4 8 golden” until the downtown market’s 3 7 recent sudden change of fortune. Philadelphia 2 6 “Now it’s wait and see.” Infill apart- ments remain the best investment 1 5 bet. The venerable Galleria market, 4.7 0 4 meanwhile, loses more luster, and '93 '95 '97 '99 '01 '03 3 most other suburban nodes decline even further. As the energy industry 2 museums, and cultural institutions Minneapolis goes, so goes Houston. But recent supply a wealth of urban amenities. 1 diversification — trade, computers, But anti-city sentiment at the 0 space, and medicine — may cushion '95 '97 '99 '01 '03 Pennsylvania statehouse and fractious the downside. local government hamper the city’s
progress to full-bore 24-hour status. 8 in the enervated economy and you’ve Recession impacts on lowered tax got real problems. Empty suburban 7 revenues will compromise city office buildings can be picked off at services — poor schools remain a 6 pricing “far below” replacement cost. festering problem. 5 Apartments show increased vacancies, and infill multifamily should be an 4 4.5
investor target — commuter 3 frustration has made close-to- Houston 2 downtown living a preferred lifestyle. Retail remains a steady performer. 1
This northland city must settle in for 0 a big chill — anticipate a “slow” thaw, '93 '95 '97 '99 '01 '03 and extended market convalescence.
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DALLAS NEEDS TO “BUILD A MOAT AROUND ITSELF AND STOP NEW CONSTRUCTION FOR A WHILE.”
Phoenix Denver Atlanta
This Arizona sprawl town disappears Mile-High takes the survey’s biggest Slammed by a jobs slowdown, excess from many investors’ radar screens. fall. Bleeding companies soil the development, and infrastructure “It’s hard to make money where Rocky Mountain foothills — problems, Atlanta has been “beat up someone can just slap up a new office Lucent, Qwest, X/O Communi- on all fronts.” Telecom’s implosion building or apartment house right cations, Global Crossing, JD delivers a major blow, and a small next to you. Land is too available Edwards, and a bunch of mutual manufacturing base offers little and there’s no discipline.” Office cushion. This market “borrowed buildings can be bought at $70-per- 8 growth from the future. Now it’s square-foot bargain-basement pricing, 7 reverting to the mean.” Interviewees
but “it’s not a no-brainer to come 6 indicate “no real opportunities,” but out ahead.” Says a large pension watch for some distressed selling to manager: “We don’t spend a lot of 5 surface. Wait till 2004 for recovery to time there.” Phoenix benefits from 4 start. “Too much vacant space needs Denver 4.4 proximity to Southern California — 3 to be absorbed.” In the longer term, affordable housing and “a friendly” sewer and water issues will curtail business environment make for a 2 market expansion and increase the low-cost alternative. But it has 1 cost of living. “We have too many
become a back-office backwater, not 0 people and not enough resources.” For a headquarters city. Tourist travel and '93 '95 '97 '99 '01 '03 a metro area that has lived off cheap the hotel business should rebound growth, the next decade could be once post-9/11 declines have run fund managers, to name a few. “No more daunting. Expect the Buckhead their course. Retail is the best major employer is doing well.” and Midtown subcities to enjoy the defensive play, with greatest upside Developers, meanwhile, should have best prospects, as more people potential when a recovery starts plenty of time to sample the great gravitate toward the area’s center and (probably not until 2004). quality of life in Colorado — skiing, away from sprawl-related congestion. golfing, and mountain biking. All The 9-to-5 downtown “limps along.” property sectors are oversupplied in
8 the face of plunging demand. “2003 8 will be a very tough year.” Nobody 7 7 counts on a miraculous telecom 6 resurrection to bail this market out. 6
5 High vacancies and cheapening rents 5 in suburban markets could pull 4 4 Atlanta 4.4 office tenants out of downtown, 4.3 3 which had been undergoing a 3 renaissance. “There’s always the 2 Phoenix 2 market’s X-factor — it continues to 1 be a desirable alternative to high-cost 1 0 California, without the earthquakes.” 0 '93 '95 '97 '99 '01 '03 '93 '95 '97 '99 '01 '03
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Dallas Secondary Markets
“It’s one of the worst — just “Anything in smaller markets will be and look to flip once an economic underwrite this office market priced dramatically differently recovery takes hold. “Eight out of 10 permanently to 15% stabilized [higher cap rates, inexpensive prices] years in a cycle, this strategy vacancy.” Dallas needs to “build a than in the bigger, familiar cities.” wouldn’t work. But now’s the time.” moat around itself and stop new Investors fear shallow tenant markets Institutional investors shy away — construction for a while.” Developers won’t allow for recoveries. Some less market familiarity and poor past “pull the trigger too quickly.” Now interviewees, though, see “better performance. Savvy local players demand also falters. Warehouse and relative values.” Look at prime could be well positioned. multifamily turn soft, but most buildings in each market, buy cheap, grocery-anchored retail “looks okay.” During the market low, look for
8
7
6
5 Dallas 4 4.2 3
2
1
0 '93 '95 '97 '99 '01 '03
opportunities to acquire office at “well below replacement cost and ride future recovery.” “In this market, growth comes back quickly.” The 9-to-5 downtown still struggles — it has no meaningful residential neighborhoods — although Uptown continues to thrive. Surrounding office markets close to prime exec- utive housing are holding up well.
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PROPERTY TYPES IN PERSPECTIVE
Most property types should reach n the risk/return spectrum, apartments, warehouses, and grocery-anchored retail — resilient income their cyclical bottom during 2003 Ogenerators — remain clustered in the most favorable quadrant: higher return and lower risk. But just barely. Prospects decline noticeably for downtown office and in an extended, but not suburban office, as investors worry that rising vacancy rates in the office sector could hamper performance. Meanwhile, precipitous, market decline. R&D weakens, and hotels and regional malls stabilize. Generally, the Emerging Trends surveys show risk assumptions EXHIBIT 5-1 rising and return expectations Property Markets: 2003 Prospects INVESTMENT POTENTIAL DEVELOPMENT POTENTIAL declining across all sectors. Only 5.7 Apartments 5.0 the traditional doormats — Warehouses 5.5 5.0 power centers and limited-service Community 5.5 Shopping Centers 4.8
Downtown Office 4.8 hotels — show any improvement 3.2
Research and 4.3 since last year, and these Development 3.6 Full-Service Hotels 4.3 2.7 categories still rank dead last for Regional Malls 4.3 2.7
4.2 prospects during 2003. Suburban Office 2.8
Power Centers 3.8 2.9
Limited-Service 3.3 Hotels 2.3
0 10 Poor Excellent
Source: Emerging Trends in Real Estate 2003 interviews
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EXHIBIT 5-2 Property Types – Return and Risk: 2003
Apartments Community Shopping Centers Warehouses
Return Downtown Office
Regional Malls R&D Full-Service Hotels Suburban Office
Power Centers
Limited-Service Hotels
Risk
Source: Emerging Trends in Real Estate 2003 interviews
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Of all the sectors, those perennial nterviewees see bifurcation in the regional-mall category. Fortress regional centers get high marks, but survey favorites — apartments IB and C malls grade poorly. No surprise here. and warehouses — are among All eyes focus on deteriorating office markets, where empty space proliferates and leasing activity is moribund. Prime the best positioned. Investor office buildings in 24-hour cities appear safe as long as demand remains extremely robust. near-term lease rollovers are at a minimum. Class A, quality suburban office in 24-hour nodes should scrape through Both sectors track close to too. But lesser-quality office faces considerable uncertainty. Rents have eroded, space is plentiful, and tenants have equilibrium and longer-term greater freedom to upgrade. fundamentals look sound. The worst seems to be over for full-service hotels — they endured their 9/11 shellacking and are now positioned to rebound with the economy. Development is controlled, and Again, Emerging Trends raises a expense efficiencies have kept the lodging industry profitable through the downturn. caution on the grocery-anchored retail sector — in the face of considerable investor popularity and survey support. These neighborhood and community shopping centers are un- questionably cash cows, but buyers may be overpaying, given the increasing risk posed by supermarket chain contraction and the growing presence of Wal-Mart in the grocery business. Investors need to distinguish carefully between top-tier and at-risk centers.
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“A BAD PRESS RELEASE WON’T SUDDENLY LOSE YOU 100% OF YOUR OCCUPANCY, LIKE AN ENRON OR ARTHUR ANDERSEN IN OFFICE OR KMART IN RETAIL.”
“We’re in a cyclical pause in supply/demand, but the long-term Apartments fundamentals remain solid.” Rising expenses — insurance, utilities, labor — have been a challenge. “It’s difficult to pass Strengths these costs through to tenants in a down market.” Investors harp on the demographics: increasing numbers of Best Bets young adults from the Generation Y bubble will enter the renter market over the next decade, and more aging baby Concentrate investing on B product, which caters to moderate- boomers are giving up suburban split-levels for simpler income wage earners, the prime renter group. “This mainstream apartment lifestyles. Multifamily investments — bolstered by renter market is quite substantial.” As we come out of the steady income components — historically produce the best downturn, “value-added” opportunities should present long-term returns of all major property sectors. Vacancy rates never themselves. “Many properties need capital for upgrading.” explode — they’ve remained in a “reasonable” range. “A bad Owners delayed necessary facelifts as rents softened. Expect press release won’t suddenly lose you 100% of your occupancy, opportunistic transactions for “renovation-starved” properties like an Enron or Arthur Andersen in office or Kmart in retail.” with mid-80% occupancies in markets with lower barriers to If the economy picks up, leasing activity follows — and rental development — in the Southeast and Southwest particularly. rates can adjust upward quickly. “The worst is almost over,” When recovery takes hold the tight East and West Coast metro and as usual in downturns the apartment markets will hold areas will benefit more quickly. Certain hard-hit cities may up relatively well. experience repricing. Supply never seems to outstrip demand in Southern California — everybody’s favorite multifamily market Weaknesses — where not-in-my-backyard (NIMBY) development sentiment runs rampant. Putting their trust in “compelling” trends and historic performance numbers, many investors have been overpaying Avoid for apartments, despite weakness in occupancies and rents. “Prices have been driven by demand and cheap debt.” Led by Premium class-A rental product struggles against competition Fannie Mae and Freddie Mac, lenders have opened their from single-family and condos, which offer similar upscale bankrolls. Recent buyers will get “cash flow stability, but no amenities. “It’s just more economic to buy — get some equity appreciation, because they are paying too dearly up front.” and tax benefits.” Wealthy retirees, trading in suburban homes, Construction starts have stayed too high, especially “in love-to- tend to purchase apartments more often than rent. Caveat: build markets” (the familiar suburban Sunbelt agglomerations). Premium high-rise rentals can compete in the better urban infill locations where higher-salaried single adults and young couples Apartment Summary 2003 aren’t ready to buy. Build-build-build/grow-grow-grow markets RATING RANKING BUY SELL — Atlanta, Dallas, Denver, Phoenix, and the other usual 39% 38% Investment Potential 5.7 1st suspects — show particular short-term weakness. Construction Development Potential 5.0 1st (tie) has continued there while growth in demand has short-circuited; Overbuilding Risk 5.8 5th but for the longer term, the demographics are “still fabulous.” Las Vegas and Orlando suffered big hits after 9/11. You’ll “get PREDICTED VALUE GAIN/LOSS burned” anywhere if you invest at sub 6% or 7% cap rates. 1 Year 5 Years 10 Years 2.5% 14.6% 28.5% Outlook HOLD 23% Markets remain “relatively soft” and “lackluster” through
Source for all property type summaries in Chapter 5: 2003, with subdued prospects for rent increases unless job Emerging Trends in Real Estate 2003 interviews
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EXHIBIT 5-3 — and for most people real estate means their home. Multifamily Construction Starts (Thousands of Units) Unquestionably, “it’s the investment du jour.” With many as of June 30, 2002 renters finally able to buy, tenant demand for apartments has 700 slackened, especially in markets with lower-cost starter homes. 600 Are low interest rates supporting an unsustainable market 500 bubble? Opinions are mixed: “Housing has to take a hit; it can’t 400 keep going against the grain,” maintains one interviewee, while another dismisses bubble talk as “a fallacious concept 300 manufactured by the press.” But there’s no doubt that home 200 pricing appears frothy and mortgage delinquencies are 100 increasing. “If it looks too good to be true, then it’s too good to 0 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’02f be true.” Just ask the former president of whatchamacallit.com.
Sources: Haver Analytics, Rosen Consulting Group Mold: A “Growing” Problem Tort lawyers have discovered their latest pathway to litigation heaven, sending shivers down the spines of attentive apartment investors. “Mold is the asbestos of the new century,” says a mortgage growth resumes and is sustained. Expect buyer demand to ebb lender. “It scares the *#@% out of me.” Insurers won’t provide in the face of some “irrational” pricing. When the economy coverage, and attorneys have owners at their mercy — “they’re gains steam, apartments will not disappoint. “The income turning mold into gold.” Mold has been around forever, but numbers will be there.” And you can’t ignore those great suddenly it’s a major health issue. Tenants claim any and all population trends, which should boost results for the ailments are mold-related and sue up the whazoo for damages. remainder of the decade. For five- and 10-year periods, Humid regions like Florida and parts of Texas are mold interviewees predict apartments will surpass all other sectors hotbeds, but the spores can cause havoc just about anywhere. in appreciation. The industry needs inspection protocols and standard lease Addendum language to help protect itself. Full-day mold seminars draw crowds. “No one knows how to defend against these suits.” More of a Commodity Business Multifamily has undergone a “quiet secular” change in what was a “mom and EXHIBIT 5-4 pop” business before the Resolution Trust Corporation (RTC) cleanup of the savings-and-loan debacle in the early ’90s. NCREIF Apartment Returns Institutional owners and REITs now dominate the apartment equity markets, while Freddie, Fannie, and the Wall Street 16% 14% conduits control the debt side. “We’re close to a commodity 12% business,” says a REIT executive. “Everybody sees the same 10% data and knows the same market information. It’s forcing down 8% returns and yield expectations.” 6% 4% Home Ownership Bubble? Despite the economic lull, 2% 0% low interest rates have made home buying extremely affordable -2% and pushed housing prices up to record levels in many areas. ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q ’02 “Anyone who can fog a mirror can get a home mortgage” on Sources: National Council of Real Estate Investment Fiduciaries, extremely favorable terms. Since the bear market savaged Rosen Consulting Group investment plans, “more faith than ever” is placed in real estate
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MARKETS “JUST CHUG ALONG AND DON’T GET OVERBUILT.”
Warehouse Best Bets The tried-and-true remains tried and true. Pick major, proven Strengths distribution-center hubs — Southern California, northern New Jersey, Chicago, San Francisco, and Houston. With mediocre It’s the classic defensive play: warehouse investments retain economic prospects looming, buy based on tenant credit to value better than any other property type. Owners are holders bridge you over the next two to three years, until the next cycle — “very few quality warehouse facilities change hands” — and provides real growth. State-of-the-art facilities — the high- pricing stands at a premium — “no bargains anywhere.” ceiling “boxes” with super-flat floors and various other “bells Institutions can’t find enough. Warehouse supply/demand and whistles” — are safer bets in the major hub markets where fundamentals react quickly to economic changes. A short national tenants dominate. Big box has been “over-hyped.” It development horizon means that construction spigots can be doesn’t play as well in secondary industrial markets, where turned off quickly when recessions hit. Again, in this cycle, plenty of regional companies and smaller tenants prefer more overbuilding has not been much of an issue, although traditional (“cheaper”) warehouse storage space with lower vacancies have climbed toward 10%. Markets “just chug along ceilings that more than meet their stacking needs. and don’t get overbuilt.” Renovating and reconfiguring space is relatively inexpensive, and warehouse owners have escaped Avoid some of the overhead issues plaguing other property types. Good warehouse properties are as close as you get to “risk-free” Speculative development of high-tech big-box space. Obsolete commercial real estate. buildings with ceilings under 20 feet clear. See addendum. Weaknesses Outlook Interviewees complain: “Rents never go anywhere.” “Portfolios The horizon looks “trouble free” as long as the economy are difficult to assemble.” “It’s tough to make a lot of money.” doesn’t backslide. Any manufacturing growth will boost leasing But stable, bond-plus returns with relatively little volatility activity and solidify returns. Nobody expects a robust recovery. leave most investors groping for big problems. Everybody is counting on economic improvement to buoy leasing and Addendum reduce vacancies, which have reached near still-manageable September 11 logjams 10-year highs. Just-in-Case v. Just-in-Time demonstrated that just-in-time distribution systems can get caught short in emergencies — when airports close down or Warehouse Summary 2003 customs inspectors delay shipments for closer scrutiny. RATING RANKING BUY SELL Without “just-in-case” backup storage, production lines can Investment Potential 5.5 2nd (tie) 56% 17% shut down and store shelves don’t get restocked. Some Development Potential 5.0 1st (tie) Overbuilding Risk 5.3 7th (tie) interviewees predict that a return of just-in-case systems will spur greater demand for traditional warehouse-storage space, PREDICTED VALUE GAIN/LOSS especially from shippers who depend on cross-border and air 1 Year 5 Years 10 Years distribution. “The efficiency experts need to back off from razor-thin delivery timing.” The return of just-in-case bears 3.5% 12.8% 22.6% watching. But don’t expect any decline in the use of just-in-
HOLD 27% time strategies — or in demand for big-box distribution
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EXHIBIT 5-5 New Industrial Construction Research and $50B $45B Development $40B $35B R&D space languishes in the ruins of the long-lamented tech 50 $30B wreck. No matter the market — Silicon Valley, Seattle, Boston 45 $25B suburbs, Austin — properties struggle with vacancies and 40 35$20B dearth of demand. “R&D is really hurting.” Surprise! Over the 30$15B past 20 years high-risk R&D has actually outperformed all 25$10B other property sectors. But it also registers the largest standard ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 2Q 20 ’02 deviation — i.e., the most volatility. What goes up can come 15Sources: Census Bureau, Haver Analytics, Rosen Consulting Group down hard. 10 For all the pain, interviewees retain some optimism about the centers. “JIT works.” In fact, sophisticated logistics future of software, Internet, biotech, and other research- management has dramatically reduced inventory/sales ratios as intensive industries. These markets got ahead of themselves, well as the relative amount of warehouse-distribution space but they’re still the driving force behind future U.S. economic required to manufacture and market goods. A shipper’s expansion. In fact, the economy may stagger until they primary goals are keeping costs down and reducing recover. When high-tech revives, the R&D markets should distribution times. stage a healthy comeback.
Ceiling Heights: Take 2 In the rather staid world of Compared to other property categories, R&D is small and warehouse properties, no recent topic has stirred more debate doesn’t ping on too many investor radar screens. Interviewees than ceiling heights. Should investors avoid anything below rate the sector a hold until recovery. Buyers should seek out 24 feet clear? Is big box, with its 30-foot-and-higher ceilings, distressed pricing in 2003. For a category that enjoys steep the only way to go? “The most important attribute is growth curves in up markets, opportunity beckons at the right flexibility, so tenants can configure space easily. Then you let price in down markets. the tenants decide how sophisticated they want their racking systems.” Big box remains the wave of the future, but for now it’s more suited to national distributors with sophisticated R&D Summary 2003 RATING RANKING needs, who operate out of the major distribution centers. BUY SELL Elsewhere, 24-foot clear is “safe,” but not much lower. Cross- Investment Potential 4.3 5th (tie) 28% 28% Development Potential 3.6 4th docking capability and ample truck-turning radiuses are Overbuilding Risk 6.1 3rd (tie) essential in any case. PREDICTED VALUE GAIN/LOSS Two-Tier Sales Market Institutional investors focus their acquisitions on new, higher-ceilinged distribution space 1 Year 5 Years 10 Years located in large industrial parks in the major markets. Private -0.7% 9.8% 17.6% investors, meanwhile, look for individual, older warehouses in secondary markets. REITs cross between the two markets. HOLD 44%
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“THE OFFICE MARKETS ARE FACING A MATERIAL VACANCY ISSUE — LET’S NOT KID OURSELVES.”
declines will be the order of the day. “There’s a growing Office recognition that the future isn’t getting brighter, especially in the suburbs.” Don’t expect corporations to increase space Strengths demands enough to make a difference in 2003: “Tenants are not bullish.” Most leasing brokers have “a lot of time to play a The supply side remains in relative check in most markets, as lot of golf — nothing has been happening.” Leasing probably new construction falls dramatically from its 2000 crest. Gloom won’t pick up until the second half of the year. “Signs are envelops developers as lenders shut down. The downdraft in weak, weak, and weak. Where are the tenants?” leasing rates comes primarily off bubble spikes that most investors never recognized in underwriting. Values have Best Bets actually held up. Capital flows into prime downtown properties also buffer pricing levels. “Office isn’t falling off a Buy or hold core office investments and focus on underwriting cliff.” Tenants are still paying rent on sublease space, delaying fundamentals — high occupancies, secure tenants, and few the pain for owners until leases end. short-term rollovers. These stabilized assets will make it through the market turmoil. Prime properties in 24-hour cities Delinquencies and foreclosures still sit near all-time lows — offer the best performance outlooks. “Pay the price and land- albeit uneasily. Cheap debt has bailed out performance shortfalls bank these assets to get you through the next five years.” and kept some owners from becoming “motivated sellers.” Many Barriers to new development give the edge to downtown 24- suburbs stagger, but well-leased 24-hour office “has legs.” hour office in the long term, despite the greater employment- growth prospects for suburban markets. “Discount to Weaknesses replacement cost” suggests more opportunistic investing in high-grade suburban office in 24-hour nodes. “Ride the ups Supply/demand fundamentals are nearly as bad as in the early and downs. It should be a good time to buy in this dip” before ’90s. “The office markets are facing a material vacancy issue — the next development wave starts. But pricing has to drop first let’s not kid ourselves.” Burgeoning vacancies mean decreasing — little suburban office traded in 2002. Timing will be key. income streams, especially as sublease space burns off. The unprecedented overhang of sublease and phantom (empty occupied) space is unsettling — “no one can easily calculate Avoid how much vacancy there actually is.” Vacancies “could reach Stay away from B class, commodity suburban office. The 20%” nationwide after factoring in all the unused cubicles. ultimate landlord’s market of 2000 has reversed course — “All my clients have too much space,” says a leading facilities entirely in favor of tenants. Market downturns beat up lesser- management executive. “It’s impossible to justify any rental quality product unmercifully, as tenants bail out for suddenly growth in any office market next year.” In fact, further rent more affordable and attractive A space. “Class B suburban office has quite a hill to climb.” Product in second- and third- Downtown Office Summary 2003 tier markets will take longer to come back. RATING RANKING BUY SELL Investment Potential 4.8 4th 32% 23% Development Potential 3.2 5th Outlook Overbuilding Risk 5.3 7th (tie) “It’s the economy stupid.” Without improvement, rents will PREDICTED VALUE GAIN/LOSS fall further. Under any circumstances, high vacancies translate to a delayed rebound. Interviewees agree: “Office will be the 1 Year 5 Years 10 Years last real estate sector to recover,” and suburban office will trail -0.1% 12.2% 24.5% 24-hour downtown. “Shuck and jive to ’05?” Don’t anticipate HOLD 45% any real movement in “occupancy demand” until 2004.
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Suburban Office Summary 2003 EXHIBIT 5-7 RATING RANKING BUY SELL New Office Construction Investment Potential 4.2 8th 40% 14% $70B Development Potential 2.8 7th $60B Overbuilding Risk 6.5 2nd $50B $40B PREDICTED VALUE GAIN/LOSS $30B 1 Year 5 Years 10 Years $20B
-2.1% 10.9% 21.9% $10B HOLD 46% $0B ’74 ’76 ’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q ’02 Sources: U.S. Census Bureau, Haver Analytics, Rosen Consulting Group Market rents will not jump-start until vacancies fall below 10%. Delinquencies, foreclosures, and distressed selling should increase during the year, especially in the suburbs. “Then, we’ll Hoteling Lives Here’s more evidence that office tenants be in the forefront of some buying opportunities.” won’t be expanding in a hurry when a recovery finally takes hold. Despite all the underutilized space in corporate suites Addendum today, many companies haven’t backed off hoteling programs. Salesmen and work-at-home staff still must camp in Low-Cost Space Configurations The corporate community space when they come into the office, plugging in imperative for greater efficiency and productivity just won’t let laptops and cell phones, instead of locating in assigned up. “Tenants can be expected to continue ratcheting up the permanent space where they could at least hang a family pressure for more large, cost-effective, and efficient floor plates” picture. “You can average 1.25 butts in every seat through to keep space-per-capita costs under control. Skyscrapers will be hoteling,” chortles a facilities manager. “It’s not going away.” increasingly less desirable in the future. “Short and squatty” suburban building designs will dominate new development Net-Lease Warnings Interest in net-lease transactions — projects. Practical and simple holds sway over glitz and views, triple-net lease, sale-leasebacks, 1031 exchanges — proliferates and shoehorning more people into less space has become an as investors seek safety in these lower-risk bond-like ingrained standard priority of Corporate America. Sorry, Dilbert. investments tied to tenant rents. Reasonable pricing is “hard to come by” as buyer interest pushes prices up. Sellers’ credit becomes increasingly suspect in weakening markets. The EXHIBIT 5-6 current climate calls for more caution in analyzing these deals. NCREIF Office Returns EXHIBIT 5-8 25% 20% Office Vacancy Rates 15% 25% SUBURBAN OFFICE 10% 20% 5% 0% 15%
-5% 10% -10% 5% DOWNTOWN OFFICE ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q ’02 0% Sources: National Council of Real Estate Investment Fiduciaries, ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 2Q ’02 Rosen Consulting Group Sources: CB Richard Ellis, Rosen Consulting Group
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RETAIL REMAINS THE SECTOR “EVERYONE LOVES TO HATE.”
Power Centers Summary 2003 RATING RANKING Retail BUY SELL Investment Potential 3.8 9th 12% 59% Strengths Development Potential 2.9 6th Overbuilding Risk 6.1 3rd (tie) High-octane consumer spending through the recession cushioned retail, while other sectors flagged. Grocery-anchored PREDICTED VALUE GAIN/LOSS centers — the “necessity” category — remain investor 1 Year 5 Years 10 Years
“darlings.” Current cash returns are “compelling.” The best 1.2% 8.5% 15.9% properties feature leading supermarket chains at infill locations HOLD 29% in prime neighborhoods. Fortress malls — commanding sales of $400 per square foot at minimum — provide core investors “eating the lunch” of regional supermarket chains, which are with the “most consistent income” of any property type. Less forced to consolidate stores at their strongest locations. Costco than 200 malls nationwide fall into the fortress category, and the has become the nation’s leading wine merchant. Small best of these centers are owned by a handful of major regional operators “have been crushed.” Drug stores continue a trend mall REITs, leaving pickings slim. The sector’s recent good of moving to free-standing locations, stripping strip centers of fortune has attracted capital, and B mall owners finally see exit prime tenants. Both grocery and drug stores expand their opportunities — “it’s the best time to sell in years.” Even power merchandise offerings, leaching the life-blood from what’s left of local centers have stabilized. Vacancy across all retail categories is well Mom-and-Pop stores. Of the 1,200 regional malls operating below 10% and concentrated in obsolete properties. Notably, a today, 250 will “cease to exist” in coming years, says a top mall 20-year construction boom appears to have temporarily abated executive. Many so-called B centers are hobbling along toward — projects are down to less than a quarter of the most recent oblivion with “no exits.” The unstoppable shopper may just 1999 peak. The most overretailed country in the world hardly run out of gas. At some point, record consumer debt, needs more shopping outlets of any kind. mortgage and car payments, and stock market losses should add up to curtailed spending. “The good news is consumers Weaknesses made the recession less severe. The bad news is there won’t be pent-up consumer demand to fuel the recovery as in past cycles.” Retail remains the sector “everyone loves to hate.” Many interviewees are “scared.” Pricing for grocery-anchored centers is “irrational” — or at least “fully priced” — considering Best Bets incursions on tenant lineups. Giant Wal-Mart, already the nation’s leading grocer from out of nowhere 10 years ago, is Buy the leading mall REITs to get fortress mall exposure. These companies own dog B and C malls too, but they’re reasonably well positioned to manage through problem periods and absorb Community Shopping Centers Summary 2003 any losses in their overall funds from operations. Scale and their RATING RANKING BUY SELL leverage with major tenants and vendors create advantages. Investment Potential 5.5 2nd (tie) 37% 29% Focus on quality power centers that are near leading regional Development Potential 4.8 3rd Overbuilding Risk 5.1 9th malls with top-rated “large format” retailers. “You don’t want to be too close to a Wal-Mart or Target, or an empty piece of PREDICTED VALUE GAIN/LOSS land.” Understand the risk in acquiring grocery retail and B 1 Year 5 Years 10 Years malls, and carefully distinguish stronger from weaker properties. Any mall with sales of less than $275 per square foot should be 4.4% 12.6% 22.4% priced as “a redevelopment play.” Don’t be foolish. There’s “less HOLD 34% margin of error” for buyers today. “If you make a mistake the
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downside is worse.” But the capital influx makes for great sales value and convenience. Sears installs checkout lines — look opportunities, and the window may close quickly. familiar? Increasingly, interviewees dismiss department stores as a “vestige of the ’60s and ’70s.” Avoid Internet Shopping It’s still there: the Internet. And it’s Steer clear of most B and C malls, as well as second-rank not going away. Tech-bubble hype and the demise of countless grocery and power centers with weaker tenant lineups. It’s e-retailers doesn’t change the reality that consumers are not a buyer’s market. increasingly buying more on line as technology improves and Web access expands. As a percentage of total sales, Web buying Outlook still wallows in the low single digits, but those numbers will grow steadily. While not an immediate threat to bricks The retail world lives off shoppers. Right now, it’s “in a race.” formats, Internet shopping will eventually make noticeable If the economy springs to life, jobs become plentiful, and incursions in some categories. It may be an eternity, however, interest rates stay under control, spending ought to hold up. before another Webvan or Peapod tries to crack the grocery Investors should concentrate their holdings in prime assets — business on line. “they’ll do fine.” Weaker holdings will be “definitely challenged” if consumers retreat. “Retail is no slam dunk.” Capex and Changing Formats Retailers of all stripes challenge real estate owners and drive up capital expenditures Addendum as they grab at ways to catch shoppers’ attention in an increasingly competitive and cutthroat environment. “In retail, Wal-Mart’s Inroads This “backwoods”-based, retail capex is as high as it gets.” Even neighborhood centers face Mack truck not only threatens smaller community shopping capital calls, as supermarket chains rejuggle space and change centers and grocery chains; it’s raising anxiety levels of many their looks more frequently than ever. “B malls are selling at regional mall owners in secondary markets. “Wal-Mart is a mall high cap rates. It looks like a good deal, but what about the under one roof. If you’ve got a B mall competing against Wal- costs of replacing tenants who leave down the road?” As Mart, you’ve got a problem.” Increasingly, mall owners are retailers consolidate, they exact a greater price from owners, turning to the prime discounters — Target, Kohl’s — to replace who are willing to make concessions. “The retailers who really ailing or failed department store chains. While department do well don’t pay a lot of rent. When they go bad, they don’t stores have improved bottom lines by cutting expenses, they pay rent at all. You can’t win unless you’re one of the big can’t manage to pin down winning merchandizing strategies — REITs who can push back.” most still seem to be aimed at June Cleaver and Donna Reed. Nearly 50% of mall sales comes from apparel, which struggles EXHIBIT 5-9 in a deflationary tailspin. The big discounters have the formula: Super-Stores’ Sales Cannibalization Percentage of total warehouse club, super store, department store, Regional Malls Summary 2003 Internet, and catalog sales 80% RATING RANKING BUY SELL DEPARTMENT STORES Investment Potential 4.3 5th (tie) 11% 33% 60% Development Potential 2.7 8th (tie) Overbuilding Risk 4.0 10th 40%
20% PREDICTED VALUE GAIN/LOSS WAREHOUSE CLUBS AND SUPER-STORES 1 Year 5 Years 10 Years 0% ’95 ’96 ’97 ’98 ’99 ’00 ’01 2Q 1.3% 11.2% 19.9% ’02 HOLD 56% Source: U.S. Census Bureau
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BUYERS CAN FIND “SOME VALUE, BUT NOT GREAT VALUE.”
Hotels Weaknesses Business travelers take fewer trips, forcing down room rates Strengths in full-service hotels. Companies send two executives where they used to send three. “Corporations have figured out Hotel properties never became “really distressed.” Only a they don’t need the level of travel” taken for granted in small portion experienced delinquencies. Buyers can find “more affluent times.” Some markets really suffer — in “some value, but not great value.” Right after September particular Boston, San Francisco, Miami, and Seattle. As 11, “pricing expectations fell off the map.” But with usual, institutional investors can’t get comfortable with the everybody chasing cheap assets, “they’re no longer cheap.” limited-service segments — too many operators and too Slashed development activity has been the sector’s “silver few barriers to entry. lining.” Room starts are down more than 30% from 2001 levels — and less than a third of 1998’s peak activity. Construction lenders have shut down. In addition, Best Bets operators have done “a terrific job” of controlling costs. Acquire or hold full-service, “mainstream” hotels in 24-hour Though industry occupancies slid below 60% in 2002, markets — the Hyatts, Hiltons, Marriotts, and Starwoods. break-even occupancy is down to 49%, and the sector has Newly built limited-service hotels in the better suburban remained profitable despite the turbulent environment. markets could also offer some opportunity. Look to flip in When business travel picks up, performance will accelerate, three to five years before the next development cycle takes thanks to the built-in efficiencies. Customers have “gotten its toll. Well-capitalized owners should hang on: “Why sell used to reduced standards” — less-premium soaps and coming off market bottom, if you don’t need to?” shampoos; no more turndown service. “Don’t expect them to be reintroduced too quickly.” Industry mettle has Avoid survived a severe test. Shun the luxury-resort segment — supply growth outstrips ample demand growth. Discretionary income isn’t what it Full-Service Hotels Summary 2003 used to be, and the sputtering economy isn’t likely to bring RATING RANKING BUY SELL back la dolce vita anytime soon. High capital-expenditure Investment Potential 4.3 5th (tie) 26% 17% costs drain returns, and day-to-day operations run up Development Potential 2.7 8th (tie) expenses. In downturns, the luxury segment can get Overbuilding Risk 5.6 6th hammered. You need to keep up all exemplary standards, regardless of your occupancy rate. Luxury can indeed have PREDICTED VALUE GAIN/LOSS its price for owners. Oh yes…interviewees continue to 1 Year 5 Years 10 Years dismiss limited-service. 3.0% 12.1% 22.3%
HOLD 57%
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Limited-Service Hotels Summary 2003 on budgets — company meeting splurges aren’t back on the RATING RANKING BUY SELL horizon. A war in Iraq, some other major international flare- Investment Potential 3.3 10th 15% 46% up, or a repeat of 9/11-style terrorism could short-circuit a Development Potential 2.3 10th recovery. No real estate sector would fare well under such Overbuilding Risk 6.9 1st scenarios, but hotels are most vulnerable to any events that curtail travel. However, hotels will also rebound most PREDICTED VALUE GAIN/LOSS quickly if the economy takes off. 1 Year 5 Years 10 Years 1.6% 10.2% 18.3% Addendum
HOLD 39% Cost Controls Hotel operators deserve kudos for reining in costs and maintaining operations in the black since 9/11. Besides reducing amenities, they’ve cut back on staffing, Outlook postponed training programs, and deferred needed maintenance. But investors should beware of looming price Aided by the development slowdown and economic growth, tags for those delayed renovations and upgrades. Lower hotels should show gradual, but definite, signs of occupancies have presented some cash-rich owners a chance improvement — with all indicators trending up by year end to get a jump on the competition. “It’s been a perfect 2003. Dramatic increases in revenue-per-room growth opportunity to undertake capital projects with less disruption historically occur after construction slowdowns — wait until for guests.” Despite reduced operating costs, owners spar 2004 for any pop. Business travel should expand modestly with managers over fees and alleged hidden profits that eat unless airline pricing escalates and scheduling hassles into their returns. Lawsuits abound, reinforcing institutional intensify in the face of carriers’ bankruptcy worries. But investors’ suspicions about undisclosed and questionable corporate beancounters will continue to keep an eagle eye charges by management companies.
EXHIBIT 5-10 Hotel Profitability
1996 1997 1998 1999 2000 2001 2002E
Aggregate profit $12.5B $17.0B $20.9B $22.1B $22.5B $16.2B $16.7B
Percent change 47.1% 36.0% 22.9% 5.7% 1.8% -28.0% 2.9%
Profit per available room $3,525 $4,608 $5,446 $5,566 $5,518 $3,898 $3,941
Percent change 42.7% 30.7% 18.2% 2.2% -0.9% -29.4% 1.1%
Sources: PricewaterhouseCoopers LLP (2002 estimate), Smith Travel Research
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INTERVIEW/SURVEY PARTICIPANTS 2003
Michael D. Bluhm Sandy Stice Sean Callum A.G. Edwards & Sons, Inc. Atlantic Investors Group, Inc. Catellus Commercial Group
Gary Sopko Bradley A. Olsen Michael W. Schramm Advance Realty Group Atlantic Partners, Ltd. Greg Vorwaller William C. Yowell David Blankenship Jack Berquist CB Richard Ellis Don Guarino Banc of America Securities LLC AEGON USA Realty Advisors, Inc. Douglas Herzbrun Donald L. Johnson CB Richard Ellis Investors James Fetgatter Gary J. Katunas AFIRE Bank of America Keith Honnold CBL & Associates Properties, Inc. David Kruth William L. Wilson Alliance Capital Management Belk, Inc. John S. Gates, Jr. CenterPoint Properties Trust David Twist Joseph I. Neverauskas AMB Institutional Realty Arthur P. Pasquarella Patrick Gregoire Berwind Property Group Century Park Partners LLC Tyler W. Higgins Hamid R. Moghadam James C. Bieri Bruce Megowan AMB Property Corporation Bieri Company Chadwick, Saylor & Co., Inc.
Daniele D. Bodini Randy Blankstein Douglas T. Adams American Continental The Boulder Group CIG International, LLC Properties, Inc. Jim Curtis Joseph L. Pagliari, Jr. James A. West Bristol Group Inc. Citadel Realty, Inc. American Invsco Seabie Hickson Peter Katz Scott W. Darling Brookdale Realty Group Citistates Group Scott M. Holmes American Realty Advisors Paul Dawson Stephen J. Furnary Cambridge Asset Mgmt, LLC Stephen B. Hansen Gerald M. Marshall Clarion Partners Amerimar Enterprises, Inc. Andrew W. Mackay Capri Capital George Pandaleon Allan J. Sweet CMD Realty Investors, Inc. AMLI Residential Properties Trust Philip L. Hawkins CarrAmerica Realty Corp. Jack M. Cohen Andrew C. Shenk Cohen Financial Argus Financial Corp. F. Parker Hudson Thomas D. Senkbeil Mark W. Reiling Alton Sanderson, III Carter & Associates Colliers Towle Real Estate John P. Skram ASB Capital Management, Inc.
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Steve Disse W. Kindred Powell Joseph Versaggi Colliers, Bennett & Kahnweiler, Inc. Enterprise Financial Services, Inc. Great Point Investors
Kieran P. Quinn Thomas Wiese Ronald Lunt Column Financial, Inc. FelCor Lodging Trust Inc. Hamilton Partners Inc.
Christopher Reutershan James D. Carpenter Jeffrey A. Conrad Concord Partners, LLC First Industrial Realty Trust, Inc. Hancock Agricultural Investment Group Marc Louargand Ph.D. Douglas W. Bennett Cornerstone Real Estate Advisors, Inc. Florida State Board of Administration Charles R. Patty, Jr. Harbor Group International John Lundeen, III James J. Brinkerhoff Coro Realty Advisors, LLC Fortis Advisers, Inc. William H. Holmes Hart Advisers, Inc. Kenneth S. Moczulski Marshall Glick Crescent Real Estate Equities, Ltd. Fortress Investment Group Richard Kateley Heitman Financial Carlos Rainwater Claude J. Zinngrabe, Jr. Crow Holdings Fremont Realty Capital Philip Berins Hilton Hotels Corporation Paul H. Saylor George Callantine CS Capital Management, Inc. GCA Properties, LLC David Congdon Hines Interests Limited Partnership Gary Cunningham John Bucksbaum Cunningham Watters Properties General Growth Properties Manuel deZarraga Holliday Fenoglio Fowler, L.P. Stephen G. Jones Thomas E. Dobrowski Timothy J. Welch General Motors Asset Management Carl Manofsky Cushman & Wakefield, Inc. HSA Commercial Alan Shapiro Joseph N. Iadarola, Jr. Glenborough Realty Trust, Inc. Curt Doenges David L. Babson & Co., Inc. Hunt Realty Corp. Kurt Wright Stephen J. Pilch GMAC Commercial Mortgage Clifford Lai DivcoWest Corporation Hyperion Capital Management
Patrick S. Donahue Robert C. Goddard, III Jerry Frost Donahue Schriber Goddard Investment Group, LLC iCap Realty Advisors
David Luski James H. Kammert Greg Ryan DRA Advisors, Inc. Goldman Sachs & Co. Industrial Developments International David H. Hoster, II Michael Dardick EastGroup Properties Granite Properties, Inc.
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Paul Curbo Glenn R. Mueller Lawrence R. Gottesdiener Jay P. Hurley Legg Mason Inc. and Northland Investment Corp. INVESCO Realty Advisors, Inc. Johns Hopkins University Lois A. Smith Charles R. Beaver Walter Korinke Northwestern Mutual Life The John Buck Company Lincoln National Investment Insurance Co. Management Co. Jun Han Stephen Allison Deborah H. McAneny Harold E. Holliday Paradigm Properties John Hancock Real Estate Live Oak Capital, Ltd. Investment Group Giacomo Barbieri Theodore Leary, Jr. Paramount Group, Inc. Bruce W. Ficke Brian T. Prinn James Hutchinson Lowe Enterprises Inc. Todd L. Shaw Jones Lang LaSalle Incorporated PCS Development, Inc. Ronald Silva Jay Fitzgibbons Lowe Hospitality Group, Inc. Mark Vollmer JSC Realty & Investment Services Pearson Properties David C. DeBauche Donald A. Smith The Marshall Group, Inc. Jeffrey S. Cavanaugh Jupiter Realty Corp. James McWalters Michael Harrity David L. Rubin Robert E. Gilberg Matrix Advisors Larry Sullivan Kaiserman Company, Inc. PMRealty Advisors Charles R. Broff Robert Schau Mellon Financial Corporation Nicholas G. Buss, Ph.D. Kansas Public Employees’ Kim McNeil Retirement System Charles Davis PNC Real Estate Finance Daniel P. Guenther James S. Smith Metropolitan Life Real Estate A. Floyd Lattin Kensington Realty Advisors, Inc. Investments Praedium Group LLC
Tracy Wong Michael Grupe Larry Krueger Kilroy Realty Corporation NAREIT Prentiss Properties
Charles J. Schreiber, Jr. David P. Linn Randall C. Mundt Koll Bren Schreiber Realty Advisors National City Investment Principal Capital Management Co. Steven Fessler Rodney R. Vogel Leggat McCall Properties Michael Chase Principal Capital Management, LLC New England Realty Resources Michael McNamara David Bradford Lehman Brothers Glenn Rufrano Kevin R. Smith New Plan Excel Realty Trust, Inc. Prudential Real Estate Investors W.B. Brueggeman L&B Realty Advisors, Inc.
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Daniel Knezevich Jonathan D. Barry Henry W. Haunss, Jr. Quest Realty Advisors Spectrum Realty Advisors, Inc. UBS Realty Investors LLC
Scott Rogers Jon M. Braeutigam Vincent Sanfilippo Real Estate Capital Advisors, Inc. State of Michigan Department Urdang & Associates Real Estate of Treasury Advisors, Inc. Wade Goetz Regent Partners, LLC Tarak Patolia Patrick Duncan Sterling American Property, Inc. USAA Real Estate Co. Patrick O. Mayberry Riggs & Company Richard B. Stern Devon W. Olson Storage USA, Inc. Utah Retirement Systems Robert Gray Rockwood Capital David Sims Michael D. Fascitelli Strategic Hotel Capital Vornado Realty Trust Arthur Margon Kenneth T. Rosen Peter G. Aylward Cory A. Carlson Rosen Consulting Group Strategic Property Advisors Inc. Washington Capital Management, Inc. Anthony W. Deering William S. Friedman The Rouse Company Tarragon Realty Investors, Inc. Thomas Regnell Washington Real Estate Asieh Mansour Peter L. Katseff Investment Trust RREEF Funds Tennessee Consolidated Retirement System Edward J. DiOrio Bruce A. Eidelson Sean Tabor Russell Real Estate Advisors David Weymer WCB Properties Thayer Lodging Group Christopher M. Casey Robert H. Glaze Secured Capital Corp. Anthony J. Pierson Weybridge Capital Investors Times Square Real Estate Investors David Weiner Michael J. Wengroff Sentinel Real Estate Corp. David C. Pahl WF Capital Advisors, LLC TMW Real Estate Group Richard S. Sokolov Ken Goldfine Simon Property Group Ralph Tullier Zenith Management Co. Hotels Trammell Crow Company Marshall D. Lees Slough Estates USA Inc. Erwin K. Aulis Matt Haley Arthur I. Sonnenblick Transwestern Investment Company Sonnenblick-Goldman Corp. Bob Godard Marvin Sotoloff Triad Properties SP Realty Partners Ltd.
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