The New Millennium Party Isn't Over Yet.

Here are 10 market predictions for commercial real estate. Read them and prepare for the real estate opportunities and pitfalls that greet the new millennium.

WELCOME TO THE NEW MILLENNIUM!

What a legacy we have inherited from the 1990s. Instead of an apocalypse from the Y2K bug, we are facing one of the strongest economies and the most prosperous real estate market ever.

Vacancies are near record lows and rents are rising steadily across most markets. The integration of the real estate market into the global capital market has led to a more responsive capital supply and more discipline in the space market. As a result, the credit outlook for real estate remains very bright.

However, challenges lie ahead. Rising price volatility has raised the financial risk of the real estate business. Increasing risks and declining spreads will force lenders and operators to be lean and mean in search of profit. The advent of the Internet and the rise of e-commerce will continue to influence the demand for space, and may eventually affect how real estate is funded.

Now that the hangover from the millennium parties is gone, let us review what happened during the 1990s and bring out the crystal ball to map out the future.

1990s: The dawn of a new era

Perhaps the biggest story in commercial real estate of the 1990s was the rapid rise and increasing dominance of public capital in the commercial real estate market. In the short space of a decade, the public real estate capital market grew more than 23 times to reach a total market capitalization of approximately $400 billion. The influence of the public capital market on commercial real estate goes even further. We estimate that public real estate capital owns, controls and finances more than $700 billion of commercial real estate (see Figure 1).

As public capital becomes more dominant in the commercial real estate market, a new era for the commercial real estate market has emerged. Commercial real estate has lost its protective shell of targeted asset allocations and must compete with other industries directly for investors' capital. Driven by maximizing short-term returns, the "smart money" from the public capital market is much more liquid, opportunistic and impatient. It enters the market quickly when profitable opportunities are present, and flees at the first sign of trouble. The magnitude and velocity of the new capital flows into and out of a market or a sector will resemble nothing we have seen in the real estate market before.

The industry got its first real taste of the new era during the summer of 1998, when external events in the global capital market caused a significant increase in the real estate risk premium, despite generally sound real estate market fundamentals. In the two months following the Russian government default on its loans and the subsequent massive flight to safety, the risk premium on commercial real estate debt and equity went through the roof. Liquidity disappeared from the real estate market almost overnight. Many poorly capitalized and overly leveraged real estate companies closed their doors or filed for Chapter 11 bankruptcy protection after suffering heavy losses.

In all likelihood, the 1998 experience is only a prelude to what is to come. Public capital is here to stay and will continue to influence how real estate is funded, priced and managed. Its increasing presence will also change how much, where and when space will be delivered--which will consequently affect real estate's future performance. This article summarizes our 10 predictions for the new millennium.

Prediction I: Public capital is here to stay

The real estate investment trust (REIT) and commercial mortgage-backed securities (CMBS) markets are here to stay. Although they may occasionally be out of favor, REITs and CMBS offer unique risk and reward characteristics to investors. For example, REITs provide investors--especially small individual investors--with a vehicle to diversify into commercial real estate. With high dividend yields, REITs are relatively low-risk income investments and have performed well over the long term. CMBS provide fixed-income investors the liquidity and flexibility to manage their risk exposure and yield expectations. As long as prices are right, there will always be demand for REITs and CMBS, and investment bankers will be more than happy to profit from meeting this demand.

Furthermore, there is plenty of room for both REITs and CMBS to grow. Currently, REITs own and control only about 10 percent of the $4 trillion of commercial properties. Meanwhile, although CMBS outstanding have skyrocketed by more than 30 times over the last 10 years, only 17 percent, or approximately $250 billion, of commercial and multifamily residential mortgages have been securitized (see Figure 2).

Prediction 2: More price volatility

A strong public capital presence in the commercial real estate market will inevitably lead to more price volatility. Because expectations play a significant role in public market pricing, commercial real estate will be priced not only on its own risk and rewards, but also on the capital market's perception and pricing of risk.

Changes in the public capital risk premium will at times have a stronger influence on real estate pricing than real estate market fundamentals. Indeed, this is exactly what happened in the summers of 1998 and During both periods, CMBS spreads widened dramatically, along with the swap curve, despite the record low commercial mortgage delinquencies and strong real estate market fundamentals (see Figure 3). As long as a significant amount of public capital remains present in the real estate market, real estate price volatility will be high.

Prediction 3: Stronger real estate credit expected

The credit quality of commercial real estate in the new millennium will be stronger than we have experienced in the past three decades. We expect that long-term expected delinquency rates will fluctuate in a narrow band of around 1.5 percent per year. We see few circumstances where the debacles of the late 1980s and the early 1990s will be repeated--especially since real estate capital flows have become more responsive to real estate market fundamentals and pricing changes in the global capital market. This has made construction more responsive to demand and the perceived risk in real estate. Thus, real estate market fundamentals will become more stable. The credit risk of commercial real estate will be lower as a result.

The current health of the commercial real estate market should also provide a comfortable cushion against any near-term problems. The commercial mortgage delinquency rate is currently near an all-time low. In the third quarter of 1999, the delinquency rate of commercial mortgages held by American Council of Life Insurers (ACLI) member companies was 0.31 percent, down from 0.57 percent the year before. If a recession were to occur, the impact on real estate would be minimal. Given the near-record low vacancies and delinquencies, real estate debt products are well cushioned against the impact of a mild recession.

Furthermore, the current conservative valuation of commercial real estate should help real estate credit quality in the near term. As measured by the yield difference between real estate and 10-year Treasuries, commercial real estate is the most conservatively priced in decades (see Figure 4). As of third-quarter 1999, the real estate income premium over 10-year Treasuries was 300 basis points, which is very wide when compared with the negative 300 basis point spread in yield difference between the Standard & Poor's Index and the same Treasuries. The current conservative valuation of real estate should provide a significant underwriting cushion for commercial mortgages.

Prediction 4: Market cycles won't go away

The advent of the public capital market has provided a safety valve for keeping excessive development in check. However, it will not completely shield select property segments or metropolitan areas from overbuilding. The inherent problems associated with developing real estate will make temporary overbuilding in some high-growth markets inevitable.

Because many commercial properties are completed in a lumpy fashion, market supply may temporarily exceed demand. Furthermore, the construction lag for most properties is long, which forces developers to build for projected demand--a moving and very volatile target. Either a too-optimistic forecast or an unanticipated shift in demand could result in localized overbuilding.

Prediction 5: A more modest demand for financing

We will see a slight decline in financing demand over the next couple of years. The wave of refinancing activity during the past few years has removed many properties from the refinancing market. The low interest rate environment has induced many borrowers to refinance their properties early, and to lock in low interest rate loans for mostly 10-year terms. As a result, future rollover demand will be rather limited. The recent hike in interest rates certainly has not helped, as many borrowers have postponed their refinancing decisions until the direction of interest rates becomes clearer. We expect that rollover demand will fall below $100 billion a year, down from around $200 billion during the mid- to late 1990s.

Slower value appreciation will also hinder the growth in demand for new mortgages. The growth in real estate values has apparently slowed and will continue to moderate across all property types in the near future. With REITs being net sellers of properties, the demand for investment real estate will remain weak. Thus, without significant value appreciation, the debt-bearing capacity of existing commercial real estate will grow slowly.

The expected decline in new construction will not help the demand for new permanent financing either. According to F.W. Dodge, Lexington, Massachusetts, commercial real estate construction declined in 1999. We expect the construction level will continue to decline over the next couple of years. New construction and value appreciation will probably add $100 billion in new financing demand per year, down from about $140 billion in 1998. Overall, we expect the demand for commercial mortgages to be around $200 billion a year, down from around $300 billion a year during the late 1990s (see Figure 5).

Unfortunately, despite the decline in demand for mortgage financing, we expect commercial real estate lending capacity to grow. During the past two years, all major categories of commercial mortgage lenders increased their commercial mortgage holdings, with CMBS issuers leading the pack with an $115 billion increase. Although some will exit, many CMBS conduits will stay in business.

With the recent passage of the Gramm-Leach-Bliley Financial Modernization Act, we expect many large money center banks will enter the life insurance business. This will further boost the demand for long-term, fixed-income products with high yield and strong call protections such as commercial mortgages. As a result, we expect that the spreads on commercial mortgages will be under significant downward pressure over the next two years.

Prediction 6: Solid performance for apartments expected

Fears of widespread overbuilding and the ultimate demise of the apartment market in recent years have been greatly exaggerated. While apartment starts have increased substantially from the lows of the early 1990s, they remain modest at around 300,000 units, barely one-half of the level during the mid-1980s. Meanwhile, apartment demand has been surprisingly resilient, despite a number of potentially negative demographic and economic trends, such as the increased affordability of homeownership and the decline in the prime rental age cohort of 25-34.

Apart from a few isolated instances in some rapidly growing metropolitan areas such as Dallas, Houston and Orlando, the apartment market remains in a state of equilibrium. After a slight uptick in 1998, vacancy rates in apartments with 5 or more units have begun to decline, reaching 8.7 percent in the third quarter of 1999, according to the U.S. Census Bureau.

Apartment investment performance also has been strong. While the total return on apartment equity investments has eased from a high of almost 14 percent in 1998, it remains a solid 11.6 percent for the year ending September 30, 1999, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). Furthermore, there are virtually no apartment mortgage delinquencies. According to ACLI, apartment mortgage delinquencies continued to decline, reaching a record low of 0.11 percent in the third quarter of 1999.

The overall outlook for the apartment market calls for continued solid, steady performance. While apartment demand will remain weak, at around 250,000 units per year for the next couple of years, so will apartment supply. We expect apartment completions to be about 300,000 units a year. With the help of obsolescence, apartment market fundamentals should remain stable or may actually improve slightly over time. As a result, we expect apartment mortgage delinquencies to remain low in the future.

Prediction 7: Hotel demise overly exaggerated

Hotels have gotten a bad reputation lately. The pessimistic outlook has driven down the share prices of hotel REITs. After a loss of 52.8 percent in 1998, hotel REITs had another miserable year in 1999, delivering a total return of -16.2 percent. Most lenders have stopped making hotel loans altogether.

Much of the blame should be placed on renewed hotel construction. Driven by record profits, the hotel market is experiencing a building boom similar in magnitude to that of the 1980S' boom. Although it eased during 1999, after reaching near-record levels in 1998, hotel construction remains more than 36 percent above its long-term average. The increase in new-room supply for the first three quarters of 1999 continued to outpace the increase in room demand, according to Smith Travel Research, Hendersonville, Tennessee. Furthermore, overbuilding--which previously had been concentrated in the limited-service segment and lower-tier extended-stay hotels--is now occurring across all but the budget segment.

The increase in new-room supply has led to a decline in occupancies. Overall occupancies fell to 65.2 percent in the third quarter of 1999, down 0.5 percent from year-ago levels. This marks the fourth consecutive annual decline. Growth in revenue per available room (RevPAR) has slowed from 3.6 percent in 1998 to 2.4 percent during the first three quarters of 1999.

However, the drop in occupancies has been more than offset by hotel owners' ability to raise average daily room rates and by improved operating efficiencies. For example, hotel break-even occupancy rates are now estimated to be around 55 percent, down significantly from the 63 percent levels of the early 1990s. Consequently, despite the deteriorating fundamentals, the hotel industry is having a banner year. Pretax profits are estimated to reach a record $23 billion in 1999, up significantly from the $20.9 billion posted in 1998. At the same time, hotel mortgages continue to post stellar performance. The hotel mortgage delinquency rate continues to hover around 0.5 percent, only 20 basis points higher than the overall commercial mortgage delinquency rate.

The outlook for the hotel market, barring a recession, is not as dim as public equity pricing suggests. In addition to improved operating efficiencies, the hotel market will also benefit from declining construction. We expect the shortage of hotel financing will continue to restrain construction activity. With greatly depressed hotel REIT share prices, equity financing for new-hotel construction is also expected to decline over the next couple of years. However, given the near-record levels of hotel construction starts during the past three years, we expect that hotel market fundamentals will get worse before they get better.

Because the majority of the new construction has been concentrated in the limited-service segment and lower-tier extended-stay hotels, occupancy rates and RevPAR growth in these segments will remain under pressure in the near term. The bright spots will continue to be luxury and upscale hotels. With limited new construction of luxury and upscale hotels, the outlook for these segments remains bright with strong occupancies and healthy growth in RevPAR.

Prediction 8: Industrial performance will ease with a slower economy

Industrial properties, a perennial favorite of investors, continue to be steady performers. Despite some negative trends that could have affected performance, the industrial market has produced solid returns for equity investors. According to NCREIF, warehouses returned a total of 11.6 percent for the year ending in the third quarter of 1999, down slightly from the year-ago figure of almost 16 percent. The high credit quality of industrial mortgages also reflects the overall health of the market. According to ACLI, industrial mortgage delinquencies remain virtually nonexistent, at 0.18 percent.

However, some cracks are beginning to appear in the industrial market. In particular, the sector faces the risk of slower demand growth amid increases in supply. On the demand side, the sector faces some negative trends, including reductions in manufacturing employment and more efficient inventory management, which has led to a declining inventory-to-sales ratio. Over the past few years, strong economic growth and international trade helped offset these problems. However, as the economy slows in the future, these trends could reveal a more pronounced effect on demand.

On the supply side, warehouse construction has been remarkably strong over the past two years. According to F.W. Dodge, warehouse starts reached 245 million square feet in 1999, up slightly from 1998's strong 241 million square feet. At these levels, warehouse starts are only 6 percent below the record level in 1979, and are 40 percent above the long-term average. As a result, industrial vacancies are expected to increase to 7.8 percent in 1999, up from 6.9 percent in 1998--marking the end of seven consecutive years of tightening. Not surprisingly, rent growth, which spiked up 9.7 percent in 1998 according to Boston-based Torto Wheaton Research, is expected to be only 4.4 percent in 1999.

While the performance of the industrial sector is expected to ease over the near term, the outlook remains generally favorable. Warehouse construction appears to have peaked and should ease over the next couple of years. As long as construction activity moderates, the warehouse market should remain near equilibrium. Vacancies have bottomed out and are expected to rise in the near term as new supply comes online. Rent growth will also moderate and should remain near the level of inflation.

Over the longer term, the outsourcing of the warehousing function and improved inventory management practices will continue to reduce the amount of space required per unit of economic output. However, steady economic growth will lead to overall gains in inventory levels. Demand for warehouses will remain steady, driven by economic growth and the increasing globalization of trade. International trade as a share of gross domestic product (GDP) will continue to increase, boosting demand for warehouse space in port cities such as Miami and Los Angeles and in major airline hubs such as Atlanta. In addition, Internet retail is expected to grow explosively, which will further increase demand for warehouse space as inventory shifts away from retailers and back to distributors.

Prediction 9: CBD office will be the shining star

The economic recovery of the 1990s and the ongoing information revolution has done wonders for the nation's office market. Demand for office space has been very robust, with more than 1.4 million white-collar jobs created over the past two years alone. Many cities, such as San Francisco, Seattle and Washington, D.C., have seen low single-digit office vacancies. With such strong demand and, until recently, very modest construction activity, office rents have spiked in many markets. Rents are projected to grow by 11 percent in 1999, according to Torto Wheaton Research, following near double-digit growth in the previous two years.

After a spectacular performance of almost 20 percent total returns in 1998, office markets delivered a total return of 13.4 percent for the year ending in the third quarter of 1999--the strongest performer among the major commercial property types. In addition, the credit quality of office mortgages is sound, with office mortgage delinquencies at only 0.27 percent, according to ACLI.

However, the office market has begun to soften. The recent increase in office construction has begun to take its toll. Office construction has ramped up significantly over the past two years, causing office vacancies to increase for the first time since the early 1990s. However, most of the new office buildings are going up in the suburbs. As a result, suburban office vacancy rates are rising, and are projected to reach 10.5 percent in 1999, up from 9.1 percent in 1998. On the other hand, downtown vacancy rates continue to decline. After lagging for many years, they finally fell below suburban vacancy rates in 1998 and are projected to be 2 percent below the suburban vacancy rate in 1999.

The outlook for the office market calls for continued softening as the new supply of office space brought to market outpaces the growth in demand. Although demand for office space should remain strong, vacancy rates will continue to rise, especially in the suburbs. However, we expect new-office construction to slow and office vacancies to stabilize in the low teens in the next two years.

Meanwhile, rent growth will fall to the low single digits. Overall, we expect the office market to return to equilibrium from its currently sizzling-hot environment. Although overbuilding can occur in fast-growing markets with limited physical constraints to development, the increasing capital market discipline should dampen the overall office building cycle and keep the market near its equilibrium in the future.

Prediction 10: Retail performance will continue to bifurcate

Retail real estate had a solid yet sub-par year when compared with other property types. According to NCREIF, retail real estate lags other major property categories, posting a 9.8 percent return for the year ending September 30, 1999--down from 12.9 percent in 1998. Credit conditions in the retail market remain resilient. According to ACLI, commercial mortgage delinquencies edged up to only 0.59 percent in third-quarter 1999.

The overall outlook for retail real estate remains modest, as the retail business faces continuing structural change. Retail is increasingly bifurcating into "good retail" and "sick retail." Certain categories, such as dominant regional malls and neighborhood shopping centers, will continue to deliver strong performance. Retail real estate, especially power centers and second-tier malls, will face four key risks: unsustainable demand, continued overbuilding, consolidation and e-commerce.

While retail sales have been strong in late 1998 and 1999, they are unsustainable. Real disposable incomes are growing at around 3 percent per year, yet real consumer spending is growing at almost a 5 percent rate. The personal savings rate has fallen to record low levels as consumers spend more than they are earning. At the same time, household debt burdens and personal bankruptcies have reached record highs in 1998. With the economy expected to slow, retail sales will ease also.

The retail market also faces excessive construction and increasing location and functional obsolescence. Following many years of strong construction, retail starts are projected to reach a new high of almost 290 million square feet in 1999, according to F.W. Dodge. This is mainly because retailers, rather than developers, have primarily driven construction. Retailers have been in a continuous search for new winning formats to increase store productivity. Cutthroat competition among retailers has reduced the life cycle of stores, speeding up the pace of obsolescence.

Space obsolescence has been exacerbated by ongoing consolidation among retailers. As newer and larger retail formats emerge, smaller shops and weaker retail chains are driven out of business. Shopping-center owners are left with empty stores that may only be leased to less profitable retailers. Worse yet, some have to face completely vacant stores or even vacant centers for years, with little hope of recouping any of their investments in bricks and mortar. Certain sectors, such as discount department and toy stores, are already dominated by the top two or three national brands, which are capturing the lion's share of sales. Consolidation is likely to accelerate over the coming years, especially in fragmented categories such as grocery and furniture.

The rise of e-commerce will also challenge the performance of some retail real estate. Although currently small, Internet sales are expected to grow rapidly. By 2003, we expect that e-commerce could account for some 5 percent to 6 percent of overall retail sales. The rise of e-commerce will be deflationary to retail prices, as it weakens the pricing power of retailers by empowering consumers with more information and more choices.

While the overall impact from e-commerce remains fairly limited at this point, it will be felt disproportionately by different retail formats. Power centers are likely to face the largest threat, as many of the products sold at these stores will face more intense price competition. In contrast, the Internet is expected to have very limited impact on grocery-anchored neighborhood centers and dominant regional malls. The threat from the Internet may speed up the decline of second-tier malls that lack dominant national retail anchors, adding to the 3,800 malls that are already empty.

While the overall outlook for retail is somewhat subdued, some sectors will perform better than others. Newer neighborhood shopping centers anchored by national grocery chains will continue to perform well, as will dominant regional malls. There will be a slow and gradual erosion in value of some retail assets, particularly power centers and second-tier regional malls. Given the myriad negative trends the retail market faces, the overall investment performance of retail real estate is expected to continue to lag that of other commercial property types.

Looking ahead

As the new millennium unfolds, we are facing a new era in the commercial real estate market. Commercial real estate is no longer isolated from public capital markets. Real estate capital flows will become more responsive to market fundamentals and there will be more discipline in space supply. As a result, real estate market cycles will become smoother. Credit quality will also improve. However, real estate risk premiums will become more volatile and commercial mortgage pricing will meet more downward pressure as financing demand declines and lending capacity grows.

Looking ahead, we see no obvious crisis brewing. The commercial real estate market will be blessed with a period of relatively calm fundamentals and stable performance in both the debt and equity areas. The relatively depressed pricing on public real estate will pleasantly surprise many value investors with outsized gains in the near future. However, the more volatile asset pricing and the rising competition in the debt market will make risk management more critical for the real estate business and investors. Sound management of loan warehousing risk and leverage in the conduit business will continue to pay big dividends in the future.

Last but not least, rapidly changing market conditions also call for more nimble investment operations. As the market becomes more efficient, profitable opportunities will be harder to come by and will disappear quickly. Investors who are quick on their feet will be the ones laughing in the future.

Jun Han is managing director and Antony Wood is an investment research officer at John Hancock Real Estate Investment Group, Boston. The authors wish to thank their colleagues, Mark Gallagher and Ken Cuffee, for their helpful comments and editorial assistance.