Best year for real estate in a decade.

A recovery that was predicted to take at least seven to 10 years came to fruition in five years. The combination of steady and prolonged economic growth, a re-engineered economy on the leading edge of a global marketplace, and absence of new supply in most real estate sectors have brought the market into balance.

In some markets, the pendulum has shifted to a new extreme, with space occupancies at full capacity and nowhere to go. As with past real estate cycles, there are exceptions, new risks and new opportunities. All is not equal among property types and markets, with a number of markets still far from equilibrium.

Real estate's improved performance and future prospects are attracting capital sources at record levels. Competition increases prices and leads to new development. Speculative construction, while badly needed in many markets, must be balanced to avoid over-capacity.

Financial turmoil and recession concerns in Asia loom over the U.S. economy, which is closing in on its own 30-year record of eight years for sustained growth without a recession.

1997 Economic Overview

The U.S. economy delivered a solid performance in 1997, setting the stage for continued expansion into 1998. Job growth for 1997 hit an estimated 2.6 million, resulting in an unemployment rate below five percent. The nation's economic performance was well above expectations, with the Gross Domestic Product (GDP) expanding at 3.5 percent for the year. Growth in exports, a strong housing market and record-high consumer confidence contributed to the growth.

Since the recession of 1991, the U.S. economy has added .15 million jobs and enters its seventh year of expansion, with record-low inflation. Inflation has fallen to 1.7 percent from three percent at the end of 1992, and is expected to stay dormant at least through the first half of 1998. Most vital economic indicators point to steady performance in 1998, albeit at a more moderate pace.

The Job Market

Contrary to traditional expectations of a maturing business cycle, the job market picked up steam in 1997, with no signs of a slowdown. Monthly average net gain in jobs was nearly 257,000 for the year. This compares to an average of 212,000 jobs added in 1996. The last three months of the year generated an estimated 330,000 jobs each. This is more than double the 156,000 monthly jobs created during the same period in 1996. Overall, jobs grew at an annual rate of 2.2 percent for the year.

Consumer Confidence

The Consumer Expectations Index, which has been climbing steadily since 1993, hit I nine-year high of 111.9 in September. The October survey of consumers pointed to a rather sizable drop in optimism, with the index falling to 107.3. Throughout 1997, the index remained at historically high levels and registered well above last year's 95.7 score. The index rebounded in November and December. The Middle Atlantic region had the highest overall consumer confidence increase for the third quarter over the same period in 1996, with a jump of 35.8 percent. The lowest increase was registered in the Mountain region, which had a 3.8 percent increase for the same period.

Trade

U.S. exports of and services grew at an estimated 14.3 percent in 1997, while the value of imports expanded by 14.8 percent. The trade deficit stood at an annual estimate of $164 billion as of October 1997. Despite the ongoing trade deficit, expanding exports have contributed measurably to the economic recovery. Since 1992, the value of exports has jumped 48 percent. During the same period, trade employment has advanced by 13 percent or 3.3 million jobs. However, exports are sure to weaken as a result of the currency and economic crisis in Asia.

1998 Economic Forecast

The economy will continue to generate steady demand for commercial real estate. Growth in demand will taper off as the economy slows.

Growth in the Gross Domestic Product will fall in the two to 2.5.percent range. More moderate growth will extend the current business cycle by reducing pressure on inflation and interest rates. Declining exports in reaction to the high value of the dollar and cheaper prices abroad will be a contributor to the slowdown. In addition, corporate earnings, which rose at an annual rate of 10.4 percent in the third quarter, could disappoint Wall Street expectations in 1998, Lower earnings and stock prices could serve as another drag on the U.S. economy.

Job growth will fall just below two percent, ranging between 2 million and 2.2 million new jobs. Although this forecast represents a decline from the pace set in 1997, it reflects sustained growth at a late stages of an expansion cycle. During the two previous cycles that have been sustained for at least seven years, jobs grew at 2.6 percent and 1.8 percent in the seventh year of expansion. Those years were 1967 and 1989, respectively.

Unemployment will hover between 4.5 and 5 percent. In the next several years, a shortage of skilled workers will become a constraint to the U.S. economy. The U.S. labor force is forecasted to grow at an annual average of one percent during the next five years. Labor supply will fall well below demand even if the job growth rate is lower in the coming years.

The housing market will cool off somewhat as a reflection of slower job growth. With interest rates holding steady and income rising, demand for single-family homes is expected to remain strong. The median price of existing homes should rise five percent to reach $135,000 in 1998. New homes should sell with a median price ??cialty stores and some community centers. Mortgage delinquencies reflect these trends. According to ACLI, retail properties have the second highest delinquency rate next to office properties. As of third quarter 1997, the retail mortgage delinquency rate stood at 1.6 percent, compared to an overall rate of 1.3 percent for commercial mortgages.

As the retail property market struggles with the supply side of the equation, a strong economy, optimistic consumers, low interest rates and favorable demographics are bolstering demand. Retail sales have posted consistent gains in the last three years, averaging between 4.5 and five percent.

In 1998, sales are poised to remain steady or possibly rise moderately, as low unemployment fosters personal income growth. Changing shopping patterns, shifting consumer preferences and new means of commerce, such as electronic shopping, have intensified competition among retailers. Competition is fueling rapidly changing retail formats and concepts, which come at a very high cost to property owners and retailers. A term correction is not expected to surface, and property performance will vary greatly among retail property sectors.

1997 Market Summary

Retail sales improved by 4.2 percent for the year, showing sustained growth, albeit at a moderate pace. Consumer prices rose just 1.7 percent, posting the lowest inflation rate in more than 10 years.

Consumer confidence maintained high throughout the year, with the composite index reaching 135 in December. The index reflects a substantial improvement over year-end 1993, when it measured just over 90.

Retail starts fell for the second consecutive year, shrinking by approximately 5.1 percent to 223 million square feet. For the current cycle, starts appear to have peaked in 1995 with an estimated 263 million of $155,000, reflecting an increase of seven percent.

The trade deficit will widen as a result of cheaper imports from Asia and higher prices for U.S. goods caused by the Asian currency devaluation.

The full impact and the duration of these conditions are difficult to predict and will depend on the response from various Asian governments to correct banking, real estate and currency problems. Markets that are heavily impacted by exports to Asia will feel some of the impact, at least in the short-term. Examples include Seattle, Portland, the San Francisco Bay Area, and to a lesser extent, Southern California and Texas.

Japan's economic health, which is more heavily dependent on other Asian economies, will have a more significant impact on the U.S. economy. Exports of goods to Japan accounted for 9.6 percent of U.S. exports in 1997.

Commercial Markets at a Crossroad

Commercial real estate will reach a critical crossroad in 1998. The economic environment in 1998 will be favorable for most property sectors. Continued business expansion and job creation will translate to further demand for commercial space. Absorption of office and industrial space will be sufficient to preserve a healthy supply/demand balance for the year, but may fall short of 1997 levels. Rents and values in most property sectors will continue climbing.

The national market cycle has reached a point similar to the mid-1980's, when demand was surging and supply was falling short. Many of the forces that led to the over-building of the late 1980's and the real estate depression of the early 1990's no longer exist. Examples of these forces include ownership-driven tax incentives, unbalanced loan-to-value ratios and loose underwriting criteria. However, the risks of over-building and trading phantom value are still alive, albeit further out than 1998 in most markets.

The industry's response and discipline in light of today's improved market conditions will set the course for the next several years.

The market correction of 1994-1997 has drastically changed the current market dynamics. Thus far, construction has remained in balance (for most property sectors) and capital flows into equity and debt have been supported by real improvements in market fundamentals.

Commercial real estate players will face a number of risks and opportunities in 1998, which will register the strongest overall property performance in a decade. The overall market recovery of the past three years has finally brought most property sectors back into balance. Higher occupancy levels, improving rental income, availability of capital, soaring investor demand (private and institutional) and ideal economic conditions have created the strongest real estate market in 10 years. The combination of these dynamics is reflected in loan performance trends.

Commercial mortgage delinquencies are at a 10-year low of 1.3 percent, compared to 2.6 percent a year ago and six percent in 1993, according to the American Council of Life Insurance (ACLI).

Rising rents and improving cash-flows will spur speculative construction. As transaction prices reach - or in some cases exceed - replacement cost in many markets, speculative development will rebound. The planning pipeline and projected deliveries for 1998 already reflect this trend. While many markets face a genuine need for additional supply, maintaining a favorable supply/demand balance will become more difficult as the economy becomes harder to predict. If the market over-reacts to short-term demand, or if multiple projects are built in local markets as a result of competition among capital sources, some markets could become over-built as early as 1999.

Industrial and apartment properties have the most short-term risk, since their completion time is less.

Investors will face the toughest challenge in markets that have already experienced sizable correction.

As value investment opportunities have dried up, investment decisions have become more complex. On one hand, ample capital at competitive costs and vigorous investor appetite are bidding up sales prices in some sectors (such as Class A apartments and suburban offices). On the other side of the equation, real value gains generated through improved market fundamentals have already been factored into today's pricing. Therefore, speculation on future rental growth and price appreciation must be carefully measured against potential over-pricing.

For the first time in the 1990's, the complexity of investment decisions in these markets is further intensified by the possibility of development.

Value investments will be limited to fewer markets. Property re-positioning remains an effective vehicle for creating short-term value. Value-investment markets (as defined by having sustainable growth in rents, falling vacancies, values not far above the bottom and a shortage of new construction) have become scarce. In broad terms, Los Angeles, San Diego, Miami, Houston, Chicago, New York and Northern/Central New Jersey can generally be viewed as examples of value-investment markets.

Property-specific analysis and submarket evaluation will become more critical for investors. Evaluating investment opportunities in today's changing marketplace requires stringent underwriting criteria. Value investments can still be found in strong markets, depending on the conditions of the submarket, the asset and the investment objectives.

The current cycle remains very different from the last and stands a strong chance for longevity. Lower debt-to-equity ratios during the past five years have created a much more sound investment market compared to the 1980's.

In 1998, capital flows into real estate will sustain momentum. Competition among investors and capital sources within local markets will be the major concern.

Since the credit crunch of 1991-92 and the bottom of market in 1993, availability of equity capital and leverage has been growing rapidly. Private investors and lenders have led the charge. At the same time, Real Estate Investment Trusts (REITs), and Commercial Mortgage Backed Securities (CMBS) have become major forces behind capital flows into real estate.

Real estate investment trusts played a major role in stabilizing the market in the early '90's. Total REIT capitalization has grown from $8,7 billion in 1990 to an estimated $140 billion currently. REIT offerings are showing no sign of slowing down, as reflected in their volume during the past two years. In 1996, total offerings reached $10 billion, compared to an estimated $14 billion estimated for 1997.

Competitively low cost of capital, coupled with the importance of expanding their Funds From Operations (FFOs) to raise stock values, have created an insatiable REIT appetite for new investments. For REITs, competition can only intensify in 1998. The shortage of available Class A, institutional grade product will result in further price wars, more focus on larger Class B product and new development.

Commercial Mortgage Backed Securities have also grown dramatically and play a significant role in the market. Since 1990, the CMBS market has grown from $30 billion to an estimated $130 billion in 1996. Just over 21 percent of all outstanding multi-family mortgages are secured, compared to approximately nine percent of commercial mortgages. While the volume of issuance remained consistent in 1997, future issuance levels are not likely to rise, since interest rates are expected to remain stable. The CMBS market will remain a critical force in the capital markets, since it creates more liquidity and allows for more property diversification.

Investor demand outstripped available product in 1997. This gap may narrow some as prices climb, however, an imbalance will continue for 1998.

Many opportunity investors that entered the market as early as two to three years ago, as well as longer-term investors who have recovered or gained equity, will be sellers in 1998. Cap rates will continue falling as values rise. The general exception will be in product types that are experiencing sizable amount of new construction, such as luxury, institutional grade apartments, power centers and limited service hotels.

Development plans and land acquisitions will increase. As the real estate cycle phases out of recovery and into an expansion mode, residential and commercial land acquisitions for future development will increase. Build-to-suit projects and medium-sized speculative projects for office, modern warehouse and R&D in tight suburban markets will dominate.

Suburban office product will likely show the largest gains in rents and values, followed by Central Business District (CBD) office properties.

The projected average for gains in office values fall in the eight to 12 percent range. Hotels (driven by full service, urban properties), R&D properties and small to mid-sized apartments will trail closely, averaging gains of seven to 10 percent. Standard industrial and large apartment communities will also post gains in the range of five to seven percent on average. Community centers and regional malls will post modest gains of three to five percent.

Space availability and options will reach a new low for office and industrial tenants. The ample varieties of low-cost space have vanished in most markets. Occupancy costs in most major markets are heading up, and in a number of markets are escalating at double-digit rates. Small and medium-sized companies, which are the driving engine of the U.S. economy, will pursue cheaper alternative space options.

Demand for Class B space in core areas will grow, leading to more redevelopment of older assets. Class B vacancies have already dropped significantly and will continue to decline.

The search for lower occupancy costs will take tenants further away from central areas and beyond traditional suburban boundaries.

Higher-vacancy CBDs will gain momentum as a result of the lack of affordable office space options in suburban areas. Larger companies will be ever more attracted to lower cost secondary markets with an educated workforce. Markets that stand to gain from this trend are Albuquerque, Las Vegas, Austin, Salt Lake City, Portland, Charlotte, Raleigh, Nashville and Orlando.

Rapidly expanding medium and large companies will have a growing interest in build-to-suit facilities in tight primary markets. This trend will be more pervasive among companies with special space needs such as high-tech manufacturing, back-office, financial processing, technical support and users of large, modern distribution centers.

These trends have already taken shape in Denver, Dallas, Atlanta, Chicago, Boston, Washington D.C. and Seattle. Markets such as Phoenix, San Francisco, San Jose, Orange County and Portland will experience a number of these trends more dramatically in the next few years as a result of robust job growth in high technology and professional services.

National Apartment Market

Having led the real estate recovery, apartments have consistently been a top choice for private and institutional investors throughout the 1990's. Being on the leading edge of the recovery translated to substantial gains in rents and values early on. Average apartment price per square foot has increased by 27 percent since 1994, while the average rent has moved up 17 percent in the same period. This places apartments in the top spot among other property sectors (excluding hotels).

In 1997, apartment values gained an estimated eight percent and rents moved up an average of five percent, posting another solid year of returns. As the market worked through the real estate cycle between 1994 and 1996, apartments reached their peak. Apartment price and rent escalations began to trail the rebounding sectors of suburban office, hotel, R&D and CBD office. Furthermore, a maturing cycle and higher occupancies brought about a rebound in new construction. Although these factors have raised investor concerns to some degree, several factors still support the attraction to apartment investments.

Despite a resurgence of new construction starting in 1994, apartment vacancies have moved up moderately, hovering around six percent nationally. The market has generally absorbed the new product with only slight increases in vacancy in select local markets. New apartment construction has not had a broad negative impact on the overall market (at least not yet).

Nationally, multi-family construction starts are expected to total 280,000 units in 1997, representing an 11 percent increase over 1994. Still, new construction in 1997 was approximately 30 percent of the last market peak reached in 1985.

Absorption of new units has slowed and should result in a corresponding decline in new construction activity. Over the last 12 months, apartment absorption during the first three months after completion was down below 73 percent, from a peak of 81 percent in 1994.

High-quality smaller and mid-range multifamily properties have experienced little or no new supply during this cycle and are reaping substantially higher rent and price gains. To maximize rental income, developers have focused on the high-end, luxury market during this cycle. Most builders have targeted lifestyle renters who are willing and able to pay higher rents. Expanded in-unit and property amenities have become common in new developments.

At the other end of the scale, low-income housing also experienced an increase in construction activity, driven by tax credit advantages. These trends have left the mid-tier Class B category with minimal construction activity. Competition from higher-end Class A properties is impacting the Class B sector in some markets. However, higher Class A rents will continue to keep the Class B renter base stable in the long-term.

Apartment properties retain the strongest fundamentals as measured by loan performance. According to the American Council of Life Insurance, just 0.5 percent of apartment mortgages are delinquent, down from one percent a year ago and 3.5 percent in 1993. The overall delinquency rate for commercial mortgages is at 1.3 percent.

Widening Performance Gap Among Sectors

The Class A, luxury sector faces the toughest challenge going into 1998. Designed for the "lifestyle" renter, this sector took center stage for institutional investors and REITs in the early 1990's and now faces two major risks. Competition among newly developed apartment communities in high-growth metropolitan areas is keeping a ceiling on rent growth. Markets such as Dallas, Austin, Atlanta, Phoenix, Las Vegas, Denver and Portland, which have experienced sizable volumes of new deliveries, are experiencing the most impact from competition. At the same time, the luxury sector is competing with home purchases, since its higher-end rents are close to, or in some cases above, comparable mortgage payments.

The steady rise in home ownership has dampened apartment demand to some degree. However, first-time renter demand has not been effected and will remain strong. The nation's home ownership rate has risen to 66 percent from a low of 63.5 percent, which occurred in 1985. This trend has developed despite an increase of 32 percent in the nation's median single family price to $126,500 since 1990.

Record-low interest rates, high consumer confidence, and a 7.9 percent increase in personal income in the last three years contributed to the rise in home ownership rates. However, first-time home buyers are not participating proportionately in this trend. First-time renters had average earnings of $27,200 in the third quarter of 1997, approximately 20 percent below the minimum needed to purchase an average starter home at $107,500. The lost renter base to home ownership has primarily affected the upper-end of the apartment market.

The next 12 to 18 months will be a critical period for the national apartment market. If new unit starts fall back in line with absorption, vacancies will begin to edge down once again. This is most applicable to the high-growth markets previously mentioned. In general terms, a sizable reduction of deliveries is not expected in the next two years.

1998 Forecast

The strength of western apartment markets will continue to dominate national trends. Record low vacancies and rental increases in the San Francisco Bay Area, coupled with the recovering markets of San Diego, Orange County and Los Angeles, have elevated the California market to a top performer in the past 12 to 18 months. Although the hot rental markets in San Francisco and San Jose have lost some steam (after jumping 25 to 30 percent in the last two years), rental growth of five to 15 percent are not out of the ordinary in many California submarkets. Seattle has also secured a solid position among the strongest markets, with an increase of seven percent in rents in the past year alone. The West has also benefitted from the strength of the Portland market, which has a vacancy rate of 4.5 percent and rental growth of 4.5 percent in the past year.

A number of markets that led the recovery may have lost steam, however, most have maintained their underlying strength. Markets that are leading the current apartment cycle such as Denver, Atlanta, Phoenix and Dallas experienced drastic decline in overall vacancy between 1991 and 1995, leading to advances in new construction activity. While short-term vacancies have risen in the Class A, luxury category, job growth has remained above expectations. The deciding factor for investment returns in these markets will be the degree of cutbacks in new construction.

Vacancies will likely remain stable. San Francisco, San Jose, San Diego, Seattle, Portland, Newark, Minneapolis, Washington, D.C. and Chicago will be the tightest markets. Construction will be highest in Raleigh-Durham, Portland, Austin, Orlando, Dallas and Phoenix.

National Retail Market

On a broad basis, the retail sector is not showing the market correction that has lifted the office and hotel sectors. Despite improving retail sales in 1997 (albeit at a moderate pace of 4.2 percent), and growing demand for retail space, vacancies are rising. In 1997, more than 223 million square feet of new space was delivered, pushing the national vacancy rate up above eight percent.

The national retail vacancy rate has actually improved in the last five years, falling from over 10 percent to its current level. However, improvements in rents and values have fallen well below other property types because of over-capacity and turbulence within the retail industry.

On average, retail values have moved up nine percent since 1994, while rents have edged up 12 percent.

The subcategories of retail experiencing the most difficulty are older regional malls, unanchored strip centers and big box- discount/power centers. Older regional malls are faced with competition from newer malls rich with entertainment, diversity and convenience. In addition, concept stores such as Nike Town, Disney, Warner Bros. and Virgin are attracting consumers away from regional malls.

New concepts in retailing, coupled with the reduction of consumers' available shopping time, have become a lethal combination for older malls. The average time spent in malls has dropped from 12 hours per month in 1980 to less than three hours currently. At the same time, retail space per capita in the U.S. has increased from 13.5 square feet in 1980 to nearly 20 square feet currently.

The other major force that has shaken the retail sector is value retailing. Large, discount retailers such as Price Costco, Home Depot, Office Max, Wal-Mart and Target provided a strong alternative in the late 1980's and early 1990's. Value retailers blossomed during the downsizing era of the early 1990's, when consumers became more cautious and price sensitive. However, the market became saturated with new players in the last three years and caused a general over-capacity. Competition from value retailers has become intolerable for many smaller specialty retailers who lack their rivals' buying power and efficiencies,

Increased bankruptcies and consolidations within the small retail category have pushed up vacancies and lowered demand for spe- [INCOMPLETE TEXT FROM ORIGINAL PUBLICATION]

square feet. Despite the decline, construction starts in 1997 were well above 1992's level, when approximately 193 million square feet were started.

1998 Forecast

Older regional malls and power centers will have the highest investment risk. Older regional malls are competing against high-end Class A malls, as well as power centers. The large capital improvements required to bring these properties up to a competing level increases their risk significantly. Power centers simply suffer from over-capacity and a relentless pipeline of new product.

Anchored community centers will lead other retail subcategories. The lack of new supply and more predictable demand has placed anchored community centers among the best investment performers. However, these investments can be vulnerable to shifting demographics and neighborhood patterns.

The entertainment wave will stay strong. Multiplex theaters, full service restaurants and food courts have become integral components of modern, Class A malls. The drawing power of entertainment has become as critical as the quality of anchors in suburban malls. Mega-stores and theme stores will build on their success in urban areas by expanding more into suburban Class A malls.

The complexity and risk/return variations in the retail market will serve the astute contrarian investor well. Micro trade area analysis and specific customer targeting potential can lead to extremely lucrative acquisition and/or re-development decisions. Restructuring the tenant mix with multiple anchors to foster shopping convenience in neighborhood and community centers has been especially effective.

National Office Market

Office properties have clearly recovered faster than expected. Six years ago, the national vacancy rate had ballooned to just under 20 percent. Lease rates were falling and investors stayed far away from this sector. Office mortgage delinquencies had reached 7.5 percent of outstanding loans in 1993, and many estimates expected a recovery no sooner than 1999 or 2000.

Since 1992, the U.S. economy has created 2.4 million office jobs, posting a gain of nine percent. At the same time, the market virtually shut down all new construction, with the exception of select built-to-suit projects. The combination of these factors has driven the national office vacancy rate to nearly 11 percent; average lease rates have moved up 19 percent since 1994; and the average price per square foot has increased 13 percent.

While values have not reached their predepression levels nationally, rents are escalating at double-digit rates in a number of markets, and the office sector has fetched the position of investors' top choice. Suburban markets have led the office market recovery, with a large lead over CBDs. Substantial growth in small and mid-sized companies seeking to locate close to suburban residential areas has generated tremendous demand. The vacancy rate in the suburbs has fallen from 24 percent in 1987 to the current rate of 10 percent.

After lagging for several years, the CBD office markets have finally caught a consistent recovery track. With few exceptions, there has been a sizable drop in downtown office vacancies, as more competitive rental rates and space availability lured tenants back to the CBD. The rebound in the professional services sector (including law, finance/insurance/real estate, engineering and business services) has also contributed to the rebound.

The vacancy rate for the CBD office sector has fallen from 18 percent in 1992 to 12 percent currently.

The market correction is also reflected in the reduction of loan delinquencies. Since 1993, office mortgage delinquencies have dropped from 7.5 percent to 1.7 percent. The current delinquency rate is still the highest of all property types. This trend is expected to continue, along with further market improvements. Despite expectations of slower economic growth, 1998 will be another year of improvements for the office sector.

1998 Forecast

Demand for space will result in further declines in vacancy rates, especially in the CBD sector. Lease rates for CBD office properties will continue their climb. Vacancy for prime, Class A space in many CBD markets will fall well below 10 percent, with Tents registering double-digit increases in many markets.

The recent increase in CBD absorption 'rates does not necessarily reflect a structural shift in tenant demand. It simply represents the lack of affordable choices in suburban markets. An improvement in lagging markets such as downtown Dallas, Houston, Atlanta, Los Angeles, Philadelphia and Chicago will be more pronounced. Vacancy will be lowest in Boston, San Francisco, Seattle, Portland, Phoenix, Denver, San Jose, Minneapolis, Orlando and Salt Lake City.

Downward pressure on suburban vacancies will persist, and lease rates will continue their climb. Proximity to residential areas, available parking, flexible space configurations and more modern technical amenities will keep attracting tenants of all sizes to suburban markets. The tightest suburban office markets will be in Seattle, Portland, Chicago, Orange County, Denver, San Jose, St. Louis, Salt Lake City, Minneapolis and Nashville.

A wave of new speculative construction is unavoidable in suburban markets. While construction activity will undoubtedly rise in 1998, a large portion will still be driven by build-to-suit projects. However, construction volumes could increase sizably beyond 1998, posing a growing concern for long-term investment returns. The first wave of new speculative projects stand to post outstanding performance for investors as a result of pent-up demand. The balance of the market could be thrown off by the second and third wave of construction that would hit the market by late 1999 and 2000, especially if deliveries coincide with a slow economy.

The R&D market will continue to gain favor with investors. As a direct reflection of the booming high-tech industries, R&D/-Flex space has gone from saturation to scarcity in less than five years. While conditions for 1998 will improve further in this sector, significant devaluation of high-tech stocks or a steep decline in venture capital flows could dampen demand rapidly. These risks are compounded by the influence of the Asian turmoil on smaller, entrepreneurial companies that drive this market.

New York/Northern New Jersey Market Snapshot - Economy

The economy in New York City and Northern New Jersey continued on the pattern of growth that started in 1993. The growth in New Jersey has been particularly strong, where over 300,000 jobs have been created since 1992. In fact, New Jersey is at an all-time employment high, while registering a low 4.9 percent unemployment rate, up slightly from prior months.

The addition of jobs in New Jersey has caused slow growth of the total population. Since 1990, the population has grown at less than 0.5 percent, and is not expected to change through the end of the century. However, a population shift is occurring. Suburban and "exurban" areas are experiencing high growth rates, while older urban areas such as Newark, Paterson and Elizabeth continue the decline in population.

Total employment is also increasing in New York City, having recovered almost 70 percent of the jobs lost in the last recession. The job growth rate has stayed between 1.$ and 2 percent a year, led by the financial sector. Should this sector weaken, job growth rates could easily drop to one percent, significantly lower than most of the country. The slow job growth has maintained a relatively high unemployment rate of 8.7 percent, nearly twice the national rate. Job gains over the next 12 months should push the unemployment rate down to eight percent.

The population of New York City has continued to grow very slowly, at about 0.1 percent for the year, and a return to the more moderate growth of the 1980's, when the population jumped by four percent, is not likely. Manhattan leads the boroughs in overall growth rate, at slightly over 0.3 percent per year, while the population in Queens is actually on the decline.

Apartment Market

Overall, the New Jersey apartment market is strong, with vacancy remaining steady around eight percent. The vacancy rate varies greatly, from less than five percent in Bergen County, to greater than 20 percent in Newark. The strongest apartment market is the Hudson Riverfront, stretching from Englewood Cliffs to Jersey City. This area has experienced a drop in vacancy rates, and price per unit of sales has increased. Sales prices in New Jersey are approaching $100 per square foot, as cap rates dip below nine percent.

The vacancy rate in New York City remains steady, hovering around five percent. However, the vacancy rate should decline as inventory is reduced slightly due to the removal of almost 12,000 units a year. The vast majority of the new construction in New York City consists of luxury apartments being built in Manhattan.

Apartment Forecast

Additions to the multi-family stock will likely be offset by the removal of a significant number of units. Removals will come largely from condominium conversions, dilapidation or abandonment. As such, the vacancy rate in both New Jersey and New York City should remain steady. Rental rates will continue to rise, as newer units will not be subject to the rent control and stabilization laws that keep rental rates on older units artificially low.

Retail

Northern New Jersey's retail market continues to be strong, with vacancies below seven percent. Tight submarkets such as Bergen County, with vacancies of less than four percent, are helping to pull down the area average. Absorption of retail space, although positive, is fairly weak. Despite this, many large projects are expected to come on-line within the next year. The majority of these construction starts, as well as projects in the planning stages, are shopping malls. Among those in planning is the 3 million + square foot mega-mall planned for Carteret in Middlesex County.

Over the last several years, New York City's retail property occupancy rate has climbed above 90 percent, well above the 83 percent occupancy rate that existed five years ago. However, the last several quarters have all shown slight increases in vacancy due to a drop in absorption. Surprisingly, this softness in the market has impacted all sectors, including the prime retail areas of Manhattan, such as Madison Avenue and the revitalized Times square.

Retail Forecast

Although there is significant construction planned in Manhattan, including some projects greater than three million square feet, demand is expected to increase and keep pace with supply, resulting in fiat to slightly lower vacancy rates.

Meanwhile, in New Jersey, the increase in supply may temporarily exceed demand, resulting in a short-term increase in vacancies and a flattening of rental rates.

Office Markets

In New Jersey, the office market continues to strengthen, experiencing its third straight year of above-trend growth. The 11 counties that make up Northern New Jersey now comprise the largest office market in the nation. The overall vacancy rate for this market stands at nine percent and is falling, thus allowing owners to raise their rents. Annual rates for Class A space range from $19 per square foot to $29 per square foot in the Gold Coast area of Jersey City. The downward trend in vacancies and increase in rents has not yet resulted in the kind of speculative building that took place in the 1980's, but planning for larger projects has been on the increase, with concentrations in Jersey City and Morris County.

Due to the growth of REITs, the high-end office sales market has been active in New York City. A prime example of the REIT influence in the Class A office market is the purchase of 280 Park Avenue by Boston Properties for $371.25 million, or $268 per square foot. Vacancy and rental rates continue to rebound in Downtown Manhattan, with Tribeca and City Hall showing vacancies of less than five percent. Midtown is thriving, with rental rates approaching $40 per square foot and vacancy rates below 10 percent. This comeback has resulted in a record amount of new construction of over seven million square feet. Currently there are plans for several additional projects, including the 1.6 million square-foot Four Times square office tower.

Office Forecast

New Jersey vacancy rates should decrease 0.5 to one percent, allowing rental rates to increase as the market tightens. Until speculative building returns to this market, these trends should continue as long as the economy continues to strengthen.

The New York City vacancy should continue its downward trend, dropping slightly less than one percent. Rents should rise over the short-term, but then may flatten as new office space eventually comes onto the market.

In both New York City and New Jersey, sales prices should continue to rise, as a result of both the strength of the market in general, and the price-inflating influence of REIT purchases.