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Emerging trends in 1993.

The widely followed forecast that's the bible of the commercial real estate market says the office market recovery won't come until 1995--at the earliest.

REAL ESTATE RESEARCH CORPORATION'S (RERC) venerable forecast, co-authored this year by Equitable Real Estate Investment Management, the study's sponsor, sees the real estate cycle approaching its nadir. The plunge of values should begin to turn--as early as next year for apartments and industrial properties--and capital-rich long-term investors will begin to find solid opportunities for attractive returns and eventual value enhancement.

As in previous years, Emerging Trends' strength derives from its cross-fertilization of in-depth research and confidential interviews with industry leaders. This year RERC spoke with approximately 100 top-level real estate professionals and practitioners. Contributing to a balance of perspectives was RERC's consulting expertise and Equitable's experience managing $36 billion of real property for its clients.

Real estate remains viable

Participants agree that real estate will continue to be a viable asset class for institutional portfolios--but one that must be viewed in a new light. While it still provides diversification for portfolios of common stocks, bonds and short-term investments, real estate has not lived up to its past promise of low volatility and steady, ever-increasing performance. Also discredited is the notion that investors in equity real estate can avoid the downside of fundamental illiquidity.

It's clear that real estate is temporarily impaired as an asset class. Turnaround--defined as improvement in effective rental rates and movement toward market equilibrium--won't occur without 1) sustained economic expansion and job growth; 2) continued restraint on new construction and development; and 3) a return to liquidity, which means prices must come down enough to narrow today's chasm between buyers and sellers.

What are the chances that these conditions will materialize? While economic hopes continue to seesaw, there is little likelihood that any real estate recovery will be jeopardized by a resumption of new construction, given the current space overhang, low rents and lack of financing. With respect to the third criterion--improved liquidity--we're seeing some progress in favor of buyers. A move to repricing and revaluation is signaled by portfolio writedowns at several banks; if others follow suit it could unclog the market and ignite transaction activity. Some owners/developers are facing investment triage: to retain their best properties they'll have to sell others.

Nonetheless, the time it will take for real estate to bottom out will be lengthy, as shown in Figure 1. Overall, values will continue to drop in 1993--but not as much as in 1992. During the lull in transactions, improving the performance of existing assets will take center stage.

This will bring greater emphasis on asset management, property management, cash flow and occupancy. Investors will also be taking a hard look at alternative strategies: open-and closed-end funds, individual accounts and securitization--especially of commercial mortgage products. With luck, they'll keep in mind that it's the property itself--not the wrapper--that counts.

Real estate will operate in a Darwinian environment. Weakly performing office and industrial properties and retail malls will not survive the shakeout. Owners will also battle functional obsolescence--with the advantage going to capital-rich owners such as pension funds, who can spend additional dollars on the enhancements needed to ensure adequate returns.

Success in rebuilding the real estate industry will hinge on how well investors, lenders and developers have learned the lessons of the last few years. Guided by herd mentality, players of the 1980s tended to ignore the need for careful underwriting. Feeding on success stories, they kept swinging for the home run.

Even today, the real estate market is governed largely by perception--the spectacular failures of recent years will keep many investors out of the market. But the current emphasis on research should eventually lead to more standardized data, fostering a more empirical approach to investment. Hopefully, conservative principles will be retained when the market's prospects brighten. As Emerging Trends reminds us, single and double hitters (not home run kings) usually score more runs and strike out less often.

Prices, values and yields

The lion's share of value writedowns have occurred since 1990; over the last few years real estate has underperformed almost all other asset classes on a risk-adjusted basis. Performance data from the NCREIF-Frank Russell index, shown in Figures 2 and 3, tells the story. For the capital component of the index, declines for specific property types have ranged from 12 percent to 29 percent, averaging 23 percent. Especially significant is the fact that 62 percent to 84 percent of the writedowns have occurred in the last year; owners have finally realized that the 1990s' markets are going to be hostile and there's no quick fix in store.

Not surprisingly, real estate yield expectations edged up in 1992--about 25 basis points over 1991--at the same time that yield targets for competing capital markets hit 30-year lows. Median capitalization rates for real estate increased about 100 basis points, reflecting downward adjustments in expected income. The message is clear: investors are demanding large risk premiums to justify re-entry into the real estate market.

Prices in 1993 are forecasted to be up slightly for apartments and stable for retail and industrial. Only the battered office sector gets a thumbs-down prognosis.

The capital squeeze will continue. On the debt side, commercial banks and life companies have troubles of their own--pursued by regulators and rating agencies and faced with a mounting number of loan rollovers.

Few equity players have the cash or the courage to enter the market--though with values bottoming and lenders and owners pressured to unload properties, some may be unable to resist temptation. Pension funds will not abandon real estate, but will purchase selectively and take their time analyzing deals. Entrepreneurial capital--primarily from Asian investors--is expected to lead any upswing in buying activity.

After analyzing each potential capital source in detail, Emerging Trends discusses the pros and cons of securitization--hailed by some as the "magic elixir that will unsnarl the gridlock and bring efficiencies to the market." Securitized equity product--stymied by real estate's inherent illiquidity--is likely to capture a small percentage of the market. But the market for commercial collateralized mortgage obligations (CMOs) and their derivatives should open up and become an important new source of financing for the industry.

Cities to watch

Washington, D.C., is the favorite of this year's Emerging Trends interviewees, garnering a 6.0 on the rating scale. The central business district office in the nation's capital is weathering the real estate downturn relatively well (though the suburban office is weak), and a highly paid work force is a plus for retail and residential. Also rated over 5.0 by the panel are Atlanta and Seattle (both at 5.7), San Francisco (5.5) and Dallas (5.2), Denver (5.1) and Houston (5.0). New York--beset by aging infrastructure and high business costs--fell to the bottom of the list.

The property markets

Dominant economic, demographic and technological trends point to a "survival of the fittest" environment in most property markets over the next few years.

* Corporate downsizing and cost-cutting practices will continue to limit both office space needs and business travel.

* Growth in service-sector employment has slowed dramatically, causing a contraction of the finance-insurance-real estate sector and putting a further strain on office markets.

* Fewer people are entering the job markets, and incomes are dropping. Not only retail, but also single-family housing and hospitality markets as well, are feeling the pinch.

* Technology is transforming the requirements of office and industrial space users, pushing some older properties into functional obsolescence.

* Continuing suburbanization is draining some urban cores and threatening the dynamics of their office markets.

For the second year in a row, investors ranked apartments and single-family housing as the most promising categories in the near term. Some support was voiced for industrials and regional malls, but there wasn't a hint of optimism for office prospects.

Apartments. A lack of construction keeps apartments at the top of investor preference lists. Starts in 1991 reflected a 35-year low, and inventory is actually declining. So despite rising vacancies and stagnant rents--and a mixed bag of demand fundamentals--multifamily's performance outshines that of any other property type. Regions to target include those where population is growing, where single-family home prices are high and where restrictions on development will constrain future supply.

Single-family homes. Large public pension funds are pioneering in this relatively new investment category. Again the chief attraction is recession-induced curbs on development. Adding to the allure are:

* historically less volatile development cycles

* potentially high development profits (between 15 percent and 25 percent)

* greater liquidity (the typical sellout period for a housing development is 24 to 36 months)

* the social investment aspect of providing a source of affordable housing

Industrial. Although warehouses were ranked just behind apartments and single-family housing, investment in this category is getting riskier. The industrial market was not immune to overbuilding, and neither output nor employment has been rising. Other trends generate both concern and optimism.

* Major technological advances in manufacturing and distribution are pushing some warehouses into premature obsolescence.

* The North American Free Trade Agreement could improve prospects for some markets but lower them in others.

* Within the 1990s, some industries will fall and others will emerge, creating a need for new state-of-the-art facilities. Defense-related producers and low-skill industries are out, but the United States will continue to lead in advanced technologies such as pharmaceuticals, biotechnology, instrumentation and even high-definition TV.

Retail. Shakeout and consolidation could prune the nation's mall supply by 10 percent to 15 percent before the retail slump runs its course--leaving survivors much healthier. Capital will count and fundamentally strong malls with money to spend on enhancement will benefit at the expense of weaker ones. Generally, large malls--protected by barriers to entry and stronger lease covenants--will do best.

Demographic and economic trends--aging of the population, unemployment, low consumer confidence, a desire to reduce debt--have magnified the pain of the retailing industry. Retailers are seeking bankruptcy protection at a rate not seen since the Depression.

However, people seem to be shopping more frequently of late. And since consumer spending accounts for two-thirds of GDP, any improvement in the economy should be reflected in retail sales. But these pluses notwithstanding, it's probably safe to predict that retail developers will be out of business for a good long while.

Office. According to Emerging Trends interviewees, the depth of office market problems will delay recovery until mid-1995 at the earliest. Overbuilding and corporate downsizing, not to mention the economy, have deflated effective rents--pushing returns down more than 18 percent from mid-1991 to mid-1992.

Investors are virtually unanimous in their low opinion of this market's investment potential--ranking downtown office 2.8 and suburban office 3.1 on the 1-to-10 scale. But there's less agreement on how significant trends--corporate downsizing, demographic shifts, technological changes, regulatory demands, lifestyle concerns and building obsolescence--will have affected office markets by the end of the decade.

One issue demanding considerable attention is the fate of older properties, as buildings with Class A amenities and technological efficiencies continue to pirate tenants.

Looking at the threat to traditional downtown offices that's posed by new urban cores--also known as "edge cities"--Emerging Trends notes that many northern cities, despite their many problems, continue to capture the focus of corporate life. Greater constraints on supply represent another advantage. The report concludes that it's rash to TABULAR DATA OMITTED write off office investment altogether, but investors need to be very careful--and farsighted--in their analysis.

Hotels. Ravaged by overbuilding, overleveraging, the recession and high business costs, hotels rank last for the fifth consecutive year. Room rates lag and occupancy hit a 20-year low--60.8 percent--in 1991. In what is basically a three-tiered market, both luxury-resort product and stripped-down basic lodging establishments are doing better than full-service mid-price accommodations.

Transactions are few: not the least of investor turnoffs in this category is the high toll taken by daily wear and tear and the specialized expertise needed to run a hotel business.

Farmland. Emerging Trends closes with what it characterizes as one of the few bright spots in the real estate investment picture--farmland. Though hurt by the recession, farmers have taken advantage of high returns earned in the 1980s to reduce debt, consolidate operations and lower production costs. The result is a stronger balance sheet that should help them weather future downturns.

Farmland's illiquidity is a concern for many investors, but rental demand for investment-grade land is strong. In all, good returns combined with relatively low volatility and negative correlations with other asset types make farmland an attractive choice for the diversified portfolio.

Marilyn Robson is managing editor of Emerging Trends in Real Estate: 1993. Copies of the full report are available at $25 each from Real Estate Research Corporation, 2 North LaSalle Street, Suite 400, Chicago IL 60602 and from Equitable Real Estate Investment Management, Inc., 787 Seventh Avenue, 46th Floor, New York, NY 10019. Attention: Emerging Trends.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:real estate market forecast
Author:Robson, Marilyn
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1993
Previous Article:Understanding multifamily markets.
Next Article:Overexposed in the office market.

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