1999 marks beginning of unique real estate cycle.

The tumultuous debt and equity real estate markets of 1998 have forced the industry to change for the better, according to KPMG LLP's national real estate practice in its 1999 Outlook Industry Forecast.

Key internal and external reassessments that occurred across all real estate sectors in 1998, and which may hive significant impact on the industry in 1999, include:

* The Commercial Mortgage Backed Securities (CMBS) market, despite severe dysfunction, hit a new record of about $78 billion;

* Real Estate Investment Trusts (REITs) of all sizes conceded that growth through acquisition must be replaced by growth from within;

* Corporate real estate owners focused on ways to enhance shareholder value.

"With interest rates down and management focusing on a variety of profit improvement strategies, dividend yields on public real estate investments should continue to heat the bond market this year, and should be in the 7 to 8 percent range, with an expected total return (dividends and appreciation) to be in the range of 9 to 13 percent," said Ray Milnes, National Industry Director of KPMG's national real estate practice. Milnes believes that real estate fundamentals will remain sound in 1999. With share prices for real estate companies currently below the net value of their assets, investments in this sector are projected to be solid and may prove to be very attractive.

1999 Begins a New Cycle

After a six-year recovery period, the real estate industry seemingly reached its cyclical peak last year. While this would normally be accompanied by a wave of new "spec" development which would spark the beginning of a downward spiral in property values, newfound discipline in 1998 created a unique, stabilizing effect leading into 1999.

"There is not projected to be the dramatic reduction in values that have been typical of past cyclical peaks because we now have more lender discipline relative to new development activity," said Milnes. "For example, we are not likely to see lenders making high loan-to-value development loans for 'spec' buildings any time soon. Instead, companies will have to bring pre-leasing to the table to secure financing at a reasonable price."

"Today, the public markets help damper the ability to go out and over-buy and over-build," said Richard Smith, National Director of REIT services. "The end result is better management of existing portfolios."

Institutional Investors' New Mindset 

Milnes believes that this year will bring a change in the mindset of the institutional investor, where investment for a quick "pop" is replaced with an investment rationale that allocates funds for long-term portfolio stability. That change, Milnes believes, is partially a result of volatility in the stock and bond markets.

While there will be development activity this year, it will in no way compare to the overabundance of the 1980's. "In a maturing industry with controlled development activity, the risk that real estate values will suffer will be much more limited," concluded Milnes.

"Real estate continues to be a good hedge for institutional investors," he said. "We anticipate that they will see real estate as a sustained business that is maturing."

REITs = Utilities Plug

"The mid-1990's presented a secular transition for REITs, as the market came out of a tremendously undervalued situation. The public capital markets, fueled by arbitrage, gave the industry a tremendous boost," said Carl Kane, national director of real estate and capital markets consulting. "With the acquisition climate frigid in 1998, REIT management looked toward bottom line growth through process improvements, technology improvements and value-added services for customers. In other words, new ways to create stable cash-flow and value."

"Real estate companies cannot drive income growth just from the top line anymore," Kane said. "REITs will stabilize in 1999 and come to be viewed far and away as a utility-type investment. In essence, we'll come to terms with the reality of what a REIT truly is: 'yield plus' with a little equity thrown in."

"If one looks at how REITs are priced, it's much like a utility now," said Frank Nardozza, national director of KPMG's hospitality practice. "Instead of using high double-digit earnings multiples to price shares as we did one year ago, REITs are now priced using more modest multiples in anticipation of slowed earnings growth and more stable future dividend yields."

"Because REITs can no longer rely on earnings growth by going out and acquiring new properties, management is now focusing on accounting systems and other technology solutions to reduce and/or eliminate costs," Nardozza said. "Even apartment REITs are finding ways to better manage renters by viewing them as customers to promote brand allegiance. The hospitality sector fits this model to a tee."

Hospitality Going Private?

Nardozza believes that the hospitality industry is healthy and that profits will be up slightly in 1999. However, current share prices do not reflect this stability. Therefore, two aspects that are forecasted to continue this year include additional share buy-back programs and privatization.

"Going private should continue to be a growing trend this year, particularly with hotel REITs, because many are priced considerably low, even on the dividend," said Nardozza. "If one looks at the balance sheet, many are trading, on average, at a 10 to 20 percent discount to Net Asset Value."

"Of course, the key to going private and buying back shares is capital," added Smith. "If a company doesn't have capital and needs to sell outright, pension funds are obvious players this year because they have the cash and the opportunity to buy low."

Overall, Nardozza believes that the hospitality industry in 1999 will, for the sixth consecutive year, remain highly profitable.

CMBS: Ripe For Rebound

According to Kane, the surprising resilience of the CMBS market, despite severe disruptions, led to a new record $78 billion of issuance. Conduits continue to dominate the issuance of the CMBS market and are expected to increase market share going forward. Investment banks, the group most severely impacted by the market disruption, have retreated to a more conservative product profile.

Much of the slack for higher risk assets will be taken up by opportunity funds and mortgage REITs.

"We expect the market to continue top perform well and to re-stabilize during the first half of 1999, and to again set new records," added Kane. "On the other hand, pricing will not likely return to the market peak of 1997, though rates will still be highly affordable."

Kane concludes that as the market matures, continued success will depend upon improved technology, operational efficiency and more focused risk management.

Corporate Real Estate Breaks Down Barriers

1998 saw the further incorporation of shared services (a combination of human resources, finance and technology) among corporate real estate companies, creating more collaboration among departments and an elimination of the "silo"-type management structure. In 1999, this restructuring will continue, and the "deal"-oriented focus prior to and during 1998 will be superseded by a "management" business model that integrates the organization to reduce costs and increase efficiencies.

"Between technology support, human resources and actual real estate holdings, the typical costs of a real estate corporation is $30,000 to $40,000 per person, per year, not including benefits and compensation," said Kane. "The key to reducing this inordinately high cost per worker is to step out of paradigms and focus on collaboration between departments."

"Large corporations are taking a more integrated approach," added Smith. "The days of division heads signing off on office buildings without talking to each other are over."

Smith believes that once CFOs see how effective integration can add millions to the bottom line, they will be able to focus on the other key objective of their jobs - driving value to shareholders.

Don't Ignore Technology

One has to take a holistic approach and push the critical success factors of top management to the bottom," said Jack Gerber, senior manager for real estate and capital markets consulting. "Technology enables those processes to happen, so it's important that companies develop technology plans that support their business strategies."

Gerber believes that the real estate industry is responding quite well to technological challenges, both near- and long-term, and is pleased with software companies' response to problems caused by what Gerber calls "mom and pop" systems, whose low functionality has been pervasive for the past 20 years.

"The old piecemeal, silo-type systems of the past are being replaced with integrated accounting, property management and data warehousing systems that can talk to each other," he said. "While these systems are 'first-generation,' and will take time to develop, we are definitely headed in the right direction.'

Gerber also noted that opportunities to create value via the Internet, and especially e-commerce, by the REIT industry have not yet been realized. Most REITs are using the Internet purely as a marketing tool (Web site), rather than as an efficient information processing tool.