Report: stronger economy trumps rate concerns.

A new report from ING Clarion concludes that the benefits of a strengthening economy will likely outweigh the impact of rising interest rates for the U.S. real estate market over the next 12 months.

"U.S. View--Rising Interest Rates: Storm Signals or False Alarm," includes a comprehensive look at the broad real estate market and analysis of the outlook for specific property types.

In the report, ING Clarion notes that rising interest rates have historically created a challenge for real estate investors, but points out that there are multiple factors suggesting that the modest increases anticipated over the next 12 months will not lead to an outflow of capital from the sector.

These include property fundamentals that are improving in tandem with an expanding economy and strong corporate profits; attractive returns for real estate relative to other asset classes; the continued availability of substantial amounts of institutional capital; and the historically negligible impact that short-term (as opposed to long-term) interest rates have had on real estate investing.

"Obviously, all eyes are on the Federal Reserve and have been since before this latest round of interest rate tightening started in June," stated Dr. Will McIntosh, head of global research at ING Clarion Real Estate.

"For institutional real estate investors, we believe that the good news of a strengthening economy will likely outweigh any negative effects of rising interest rates over the next six to 12 months."

The ING Clarion report anticipates a gradual improvement in the fundamentals for most property types, noting that while "the speed and magnitude of recovery varies across properties and regions, the overall trend is positive."

* Multi-Family. The report notes that soft fundamentals, including a seven percent vacancy rate and an abundance of new supply, have not yet dampened investor demand for this property type.

It states that "the present market appears to be fully priced and that strong demand is necessary for fundamentals to keep improving." Demand is expected to firm in early 2005 as employment picks up.

* Office. ING Clarion believes that office sector is near a turning point, with U.S. office vacancy rates declining for the first time in four years during the first half of 2004. Construction levels have eased from a high of 3.5 percent of available stock in 2000 to a projected 1 percent in 2004, while demand is slowly improving. The firm expects these trends to continue in 2005.

* Industrial. Industrial space continues to see strong demand, according to the report, driven by improvements in manufacturing and trade.

ING Clarion notes that demand in this sector is somewhat market-dependent, with regional hubs that benefit from increased global trade typically outperforming. Demand for research & development space remains weak.

* Retail. Retail properties continue to turn in the strongest performance among the property types, with one-year total returns of just under 19 percent.

The report sees continued strength in the sector, as new supply remains in check and growing employment balances the negative impact of the rising price of gasoline.

Sub-sectors singled out by ING Clarion include discounters and specialty retail, lifestyle centers, and regional malls with strong tenant demand.

* Hotels. The hotel and lodging sector continues to struggle, according to the report, though it notes that there are some signs that a modest recovery is underway. There is limited new supply in the pipeline, and demand is picking up.

While fundamentals for the sector should improve in the coming year, the report notes that pricing for some hotel properties already reflects this anticipated recovery. As a result, investment performance may continue to lag other sectors into 2005.

ING Clarion notes that investor interest in real estate public debt and equity has also remained strong, and that here again rising interest rates have not yet managed to dampen investor enthusiasm for these securities.

Commercial mortgage-backed securities (CMBS) issuance is on pace to exceed the $78 billion of new issuance registered in 2003. At the same time, default rates of both public and private debt remain relatively low.

Although competition for loans is intense, there are few signs of deterioration in either underwriting standards or in mortgage portfolios, according to the ING Clarion report.

The public equity real estate market has been characterized by high levels of volatility so far in 2004, as investors reacted to the evolving interest rate picture.

The report notes that after a challenging 1Q, 2Qgains in real estate investment trusts (REITs) were concentrated in the economically sensitive hotel and apartment sectors.

Sectors expected to experience the highest levels of earnings growth in 2005 as measured by funds from operations (FFO) are hotels (17 percent, up from 11.3 percent in 2004), storage (11.2 percent, up from 7.3 percent in 2004), and mall (9.5 percent, down from 9.9 percent in 2004).