A rosy picture for real estate.

Commercial real estate is coming back so strong it is winning away investors from other asset types. The rosier outlook for real estate has brought commercial mortgage lending back in fashion after a long dry spell.

THE REAL SIDE OF THE ECONOMY IS IN PERHAPS ITS best shape since the early 1960s. Productivity has surged, real incomes have been rising, 2.3 million new jobs were created in the year ended April 1994 and inflationary forces, especially in the key area of unit labor costs, remain muted.

These positive fundamentals have paid dividends for real estate, as the job growth and income gains translate into improved demand for office and retail space and rental housing.

Direct investments in U.S. real estate appear poised to produce 10 percent to 11 percent total returns on an unleveraged basis in 1994. This may catapult real estate from underperformer to star among major domestic asset categories for 1994.

Although the rise in interest rates so far this year--and expected slowing of the economy--could cause the real estate recovery to decelerate, the impact may be mitigated, in part, because higher rates and slower growth could also further forestall an upturn in new construction. Already limited because of the overhang of supply from the TABULAR DATA OMITTED 1980s, this lack of construction means competitive pressure from new construction will be restrained. For this reason, commercial real estate may be less vulnerable to a moderate rise in interest rates than during past cycles, and less vulnerable than certain other economic sectors.

Other trends we perceive in the market account for these additional investment recommendations:

* The negative trend in retail apparel sales appears to be reversing. Gains will enhance growth in the general merchandise, apparel, furnishings and "other" (GAFO) group that is the mainstay of regional malls. We believe malls that dominate their trade areas will be the chief beneficiaries. Publicly traded real estate investment trusts (REITs) provide a viable alternative to direct investment in this category.

* We estimate that the national suburban office vacancy rate is now lower than the downtown rate. Although initial yields are attractive, investors should proceed with caution and be prepared to put additional capital into projects to attract and retain tenants. Rent spikes are still years away in most markets, implying long holding periods.

Review of 1993 performance

A modest positive performance returned to the commercial real estate group: The appraisal-based Russell/NCREIF Property Index (RNPI) recorded a total return of 0.88 percent in 1993.

For 1993, apartments posted the highest return--11.05 percent--of the five property sectors covered by the RNPI. The income component provided a strong 9.5 percent, with the remainder coming from appreciation. Declines in vacancy rates and continued low levels of new construction fueled the sector's results. The retail sector was the second best performer. It returned 5.44 percent in 1993.

Except for the Pacific division, every region of the country had a positive 1993 return. This represents a vast improvement over 1992 when every region experienced negative total returns. The best 1993 performances relative to 1992 were in the Mountain, Southern and Northeastern regions: return differentials were 10.84 percent, 9.52 percent and 9.42 percent, respectively.

Forecast for 1994

We expect that the RNPI will show a return of 10 percent to 11 percent in 1994, before management fees. We believe that overall cash flow growth will be modest because of the index's large office component, where vacancy rates will generally limit rent increases. The current 9 percent income return should be stable. Value increases in apartments and selected retail properties could add 1 percent to 2 percent in appreciation to the total index return.

We think there is a greater chance for an upside surprise than a downside one, based on solid property market fundamentals. The major risk, however, is a further rise in interest rates. Property values today are more tightly coupled with the capital markets than ever. Although appraisals tend to lag market realities and smooth some volatility, a further rise in rates would depress values because investors would require a higher rate of return (capitalization rate) to offset at least part of the impact of higher interest rates.

Lending is back

Reflecting the more stable conditions and improving prospects for much of the real estate industry, commercial mortgage lending is back in fashion. Several major life insurance companies are enthusiastic about the market because they believe they can earn higher spreads than corporate bonds provide, without taking additional risk.

Spreads for the most attractive loan transactions have narrowed to 150 basis points over Treasury issues, down from 200 basis points in the middle of 1993. The spread decline has offset some of the sting of higher Treasury yields. Even at the lower spread, mortgages appear to offer relative value compared with corporate bonds. Future default incidence is likely to be below 1989-1993 levels and loss severity should decline as property values strengthen.

In addition to the spread reduction, borrowers are also benefiting from more generous underwriting standards. During the worst of the "credit crunch," lenders were able to hold to 60 percent to 65 percent maximum loan-to-value (LTV) ratios. LTV ratios have now edged back up to the 75 percent standard and we understand some lenders would contemplate going to 80 percent for a choice transaction.

The lending rebound has been faster than we anticipated. Of further importance for property values, little if any of today's mortgage lending is funding new construction. With underwriters focusing on the cash flow that can be generated at existing rents we are not concerned about lenders developing a large appetite for funding new development.

Most signs indicate that the real estate crisis is over for U.S. financial institutions. Mortgage delinquencies, including loans in the process of foreclosure, dropped from 6 percent as of September 30, 1993, to 4.5 percent on December 31, 1993, according to a survey by the American Council of Life Insurance (ACLI). Restructurings meanwhile, grew to 9.4 percent of total loans outstanding, from 8.6 percent at the end of the third quarter and 7.4 percent at the start of 1993. Foreclosures declined to $5.9 billion in 1993, down from $6.6 billion in 1992, according to the survey.

REITs respond

Real estate investment trusts (REITs) posted solid gains during the first quarter of 1994 until the last two weeks of March. At that point, slumping stock and bond prices and an exodus from real estate sector funds reduced REIT prices sharply. For example, the Lehman Brothers price-only REIT index was up 6.7 percent for the year at the end of February, before declining 400 basis points in March. Equity REITs provided a total return of 3.08 percent in the first quarter, according to the National Association of Real Estate Investment Trusts (NAREIT). (This figure does not include REITs specializing in health care facilities.)

Non-REIT property companies in the Wilshire Associates' real estate security index had flat returns for the quarter, which still allowed them to outperform both the Standard & Poor's 500 stock index and the bond market.

While higher interest rates in response to stronger-than-anticipated economic growth present some dangers to the real estate recovery, the impact may be less on REITs than expected. In this context, REITs may demonstrate more cash flow growth than the market previously anticipated. Thus increased growth prospects would partially offset the deleterious effect of higher interest rates.

Regional reports

As always in assessing real estate, regional economic trends tend to be of equal or greater significance than national trends. The following are notes on the economies in the largest states and for certain other fast-growing markets.

NEW YORK: Signs of improvement.

Consumer inflation fell to 2.5 percent in the New York metropolitan area for the year ending in March. The 4.1 percent gain in nominal personal income during that same period produced a real gain in living standards.

Retail sales rose 3 percent in 1993. Employment growth in the state is positive, with 83,000 jobs added since employment hit its trough in November 1992. But this growth still replaces only about 14 percent of the 578,000 jobs lost in the recession.

Reductions in defense expenditures continue to hurt employment in the electronics and aerospace industries, as exemplified by Northrop Corporation's takeover of the troubled Long Island-based Grumman Corp. Slow growth among major European economies has hurt exports of industrial machinery. Uncertainties created by proposed health care legislative reforms have reduced demand for health equipment. Continued restructuring and reorganizations have resulted in layoffs across a wide range of industries in the state.

Years of above-average inflation and high real estate prices eroded the Empire state's and New York City's competitive position as centers for manufacturing. In February, New York accounted for just 5.3 percent of U.S. manufacturing employment, down from 7.2 percent 10 years earlier and 8.2 percent 20 years ago.

Nonmanufacturing jobs have fared better, with substantial gains in services employment. Service exports continue to grow in importance for the New York economy. New York still offers an unmatched array of talent in all aspects of services to U.S. and international markets. As the global economy picks up in 1994 and beyond, the outlook for the New York economy should continue to brighten.

While New York's financial services industry has suffered some losses due to the correction in U.S. stock and bond markets, so long as a long-term bear market does not develop, the brokerage firms should be able to avoid the large-scale layoffs that followed the 1987 stock market crash.

TEXAS: Outpacing the nation after troubled 1980s.

Low oil prices, although beneficial to the national economy, have had a negative impact on Texas and other oil-patch states. However, due to greater emphasis on refining rather than drilling, a greater concentration on natural gas and a more diversified economy since the collapse of the mid-1980s, the Texas economy has managed to continue to outpace the nation.

In 1993, the Lone Star state experienced a 3 percent rise in establishment employment, compared with a 1.7 percent rise for the nation. Heavy migration into the state has been a key to growth. Texas posted 2 percent population growth in the year ended July 1993. Also, recent estimates indicate that it has passed New York to become the second most populous state in the nation behind California.

The population growth has created increased demand for housing, transportation and services, providing a broad boost to the state economy.

With competitive wages and strong demographic growth, economic growth in Texas should outpace the nation during the second half of the 1990s.

Texas will also be a major beneficiary of the North American Free Trade Agreement (NAFTA), because Mexico is its largest export market. Exports to Mexico contribute about $27.6 billion each year to the Texas economy and provide about 290,000 jobs in the state, according to estimates published by those tracking the Texas economy.

CALIFORNIA: Signs emerge that it has turned the corner.

Payroll employment, which fell by 600,000 between mid-1990 and the end of 1993, has grown by 15,000 over the first quarter of 1994. California's year-over-year growth in retail sales outpaced national growth in January and February, according to Telecheck Services, Inc., a check clearing company. Housing starts in the West during the first three months of 1994 were up 40 percent year over year, compared with a 20 percent gain nationally, a possible indication of strength in the Golden State's home-building industry.

The recession in California, which started at the same time as the national recession, has now lasted three and a half years. This long downturn has generated significant pent-up demand for housing and consumer durable goods, such as motor vehicles and appliances. Provided the national economy continues to expand at a steady pace, consumer and business confidence should revive in California, setting the stage for a stronger cyclical upturn that could begin late in 1994.

Defense and aerospace downsizing will continue to hinder California's recovery over the next few years. However, just as Michigan is now less exposed to the health of the auto sector than it was 15 years ago and Texas is less dependent on oil than it was 10 years ago, so California's over-reliance on defense and aerospace is being reduced, leaving the state with a more diversified economy. Besides defense and aerospace, California's industry mix is favorable and the state's outsized share of the nation's entertainment and leisure industries and high-tech software will continue to be a benefit.

FLORIDA: It faces some challenges.

Florida experienced growth in construction and tourism in 1993 and some stabilization in its manufacturing job base. Total payroll employment has been growing at a steady pace since the recession of 1990-1991 and grew a healthy 3.6 percent in 1993. The state continues to experience some stimulus from hurricane rebuilding, although this effect is now waning.

Tourist spending has always been a major source of strength in Florida. As the national economy continues to expand, families will be more inclined to travel for vacations. Florida will also benefit from construction of a new Universal Studios park that will bring an additional 14,000 jobs to the Orlando area. The future of Florida's tourism industry--particular Miami's tourist trade--also depends on public attitudes toward adverse publicity about murders of foreign visitors in 1993. Without further such incidents, growth should improve at a reasonable pace in 1994.

Manufacturing employment, which has been a drag on Florida's economy, showed some signs of improvement, increasing 0.2 percent in December 1993 from the previous year. The main reason for the restrained manufacturing employment is downsizing of defense contracts since the end of the Cold War. According to the Federal Reserve Bank of Atlanta, Florida is expected to lose approximately 13,000 military and defense-related civilian jobs during the next two to six years as a result of cutbacks and transfers. Nationwide, more than 120,000 jobs will be lost due to base closings and realignments.

Service employment in the state grew more than 6 percent in the year ended February 1994. Hotels and amusement and recreation services are the dominant employers among services industries in Florida.

The state's percentage change in population between 1980 and 1990 was the highest in the region, at 33 percent. If the in-migration continues it will further increase demand for services, especially health services, because large numbers of seniors are settling in the area. However, health care reforms and the fear of future cost constraints may limit health services growth in the coming year.

Long term, the state's important agriculture industry also faces a challenge. Tariff protection for its citrus industry will be phased out over a 15-year period. Citrus production accounts for more than 25 percent of the Sunshine State's agricultural receipts. Near term, though, the outlook is good. The citrus crop was healthy in 1993; while crops that were affected by the drought in that year did not suffer substantial losses.

MISSISSIPPI: Its gamble paid off.

In Mississippi, casino gambling has emerged as a major force for economic growth, sparking gains in services, construction and retailing. The unemployment rate in the state averaged 6.2 percent in 1993, down from 8.1 percent in 1992. Payroll employment figures for February showed a 3.5 percent year-over-year gain, compared with 1.6 percent for the nation.

The boom in Mississippi gambling has boosted both employment and state and local government revenues. The city of Biloxi raised $1.2 million in casino taxes last year, allowing it to pay for major capital projects it has needed for years. With a significant state budget surplus in 1993, government employment grew by a substantial 1.7 percent from December 1992 to December 1993.

A record rise in personal income, strong employment growth and low interest rates have led to a healthy growth in single-family home construction. The state's lumber and furniture businesses have also benefited from the national surge in home building and revived commercial activity.

The state's casino industry has transformed a depressed Mississippi into a revenue-generating, job-creating economy. However, the state is also experiencing adverse consequences in displacement of business and in social costs, such as crime, compulsive gambling and the export of local capital. Moreover, the outlook for Mississippi is uncertain; tourism is likely to decline once casinos open in neighboring states of Louisiana and possibly Alabama. The first signs of a slowdown in the gambling boom may already be evident in modest casino job cuts announced recently. As gambling slows, Mississippi will need to find other ways to maintain its current--and uncharacteristic--economic boom.

GEORGIA: A growth pacesetter.

Since the end of the 1990-1991 recession, Georgia has emerged as one of the fastest growing states in the nation. Payroll employment rose 4.6 percent in the year ended February 1994--more than double the national rate. Substantial losses in jobs and income during the last recession caused major cutbacks in state and local payrolls that are now being reversed with 2.9 percent year-over-year growth in government employment as of February.

Georgia's strength is coming from home building, manufacturing of building-related products and the services sector. Most visible is construction related to the Olympic games scheduled for 1996 in Atlanta.

Single-family construction has been strong in 1993. The number of residential building permits issued surged 23 percent, following 17 percent growth in 1992. The median price of an existing single-family home is still just 80 percent of the national average. Partly due to the affordability of single-family homes, multifamily home construction remains weak. Preparation for the 1996 Olympics has also encouraged a moderate pickup in commercial and public construction.

Available jobs will encourage further migration to the area in the 1990s--Georgia's population grew 19 percent from 1980 to 1990--and that will further boost residential construction.

Based on substantial economic growth in 1993, Georgia's revenues are on the rise. The state's lottery, which began operating in June 1993, has also contributed to state revenue growth and is expected to provide a modest boost to state and local government employment.

One negative in an otherwise positive picture has been agriculture. Drought-related crop losses totaled about $500 million last summer.

UTAH: They are No. 1.

Utah is the fastest growing state in the fastest growing region of the nation and owes much of its recent success to the energy bust of the mid-1980s, which forced companies to downsize and diversify. State help in retraining laid-off workers allowed them to be absorbed in faster growing industries, including aerospace, computer software and financial services.

The success of Utah's service economy is largely the result of well-developed infrastructure, low taxes, competitive salaries, affordable housing and a less regulated business environment. Another lure for new business has been Utah's literate and youthful population. Until recently, Utah had been a net exporter of its well-educated population to other states.

However, Utah has not been immune to national defense cutbacks. Defense contracts have been the dominant source of manufacturing jobs, providing about 14 percent of manufacturing employment. During the 1990-1991 recession, this sector lost 3.1 percent of its jobs, in line with the experience of other states. Some of the state's manufacturing industry is in transition, moving from military products to sporting goods, air bags for the auto industry and other nonmilitary products.

Despite improving conditions in California, long-term structural problems there suggest a continued out-migration of well-educated workers over the next few years. In the year ended July 1993, Utah saw 2.7 percent population growth, much of which consisted of displaced and disgruntled Californians. If this exodus of former California residents continues to choose Utah as one of their destinations, the state should continue to grow for some time.

Michigan: Shifts into overdrive 

Although Michigan is less dependent on the auto industry than in previous business cycles, the sharp upturn in demand for U.S.-made autos and light trucks has provided a significant boost to the state's economy during the past year. Total payroll employment was up 1.6 percent year over year in February 1994.

Conclusion

A variety of national economic developments, combined with regional and local trends in many of the largest states and fastest-growing regions, have created a positive environment for real estate investment. The improved circumstances are reflected in a greater willingness by lenders to grant mortgages and at more favorable terms than in recent years. It is also evident in the early signs of recovery now visible in Southern California and Northeast markets, where real estate had been harder hit than in many other regions.

While higher interest rates can be expected to slow the rate of economic growth, their impact should not be great enough to interrupt the real estate recovery. One reason is that higher rates will impede new speculative construction. Another is that the increase in rates is due to the economy's stronger-than-expected rate of growth. That rate of growth has produced gains in jobs and incomes, which are producing improved demand for many categories of real estate.

S. Michael Giliberto is director of real estate research at Lehman Brothers Inc., New York City.