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The view from here.

To no one's surprise, 1991 is not proving to be a good year for real estate. Unfortunately, 1992 won't be much better.

Despite the glow following the successful war in the Middle East and the apparently shallow and short nature of the recession that began in late 1990, real estate prospects are not positive. For example:

* Prices are continuing to drop but not as much as panic peddlers suggest. Discounts on good real estate have been modest. Very few quality properties have come to market at prices most buyers are willing to pay.

* Yields are also declining because demand is down and absorption is slow. With few exceptions, there has been no growth in income in 1991. Oversupply will keep most markets soft well into 1992.

* Transactions sales, financings and refinancings have been incredibly slow. The market paralysis will persist well into the next year. There are plenty of buyers looking for property, but only those who are literally forced to trade will sell in a down market.

* Values are overstated in most equity and debt portfolios. Write-downs are increasing in 1991, as regulators keep the pressure on and as fund managers more accurately reflect market realities in their valuations.

* New construction has also decreased dramatically in all markets and for all land uses. That's welcome news for owners and investors in existing projects, but clearly less positive for developers and construction lenders.

Market gridlock

The most striking feature of the real estate industry in mid-1991 is the almost total lack of deals. The transaction side of the business (as opposed to development) began to stall in the second quarter of 1990, and that near paralysis has extended through mid-1991. The cause is not lack of capital. Rather, it's the wide gap between what sellers think they can get and what buyers think they should pay.

Ral estate experts almost unanimously are convinced that 1991 will be a good time to buy property or to buy debt. That is true in principle. There have been a few real bargains and some good deals this year for those with (1) capital; (2) patientce; and (3) guts. All these are needed but, realistically, not that many real estate organizations have all three.

Although it seems a good time to buy, the reverse is also true: 1991 has not been a good time to sell. Everyone who can hold on will hold on. We do not expect to see the market for equity or debt reviving until well into 1992. There will be a flurry of activity before year-end as some organizations try to put somoething on the books for 1991, but it will not substantially affect the slow pace of the market.

Capital flows

World capital markets are more fragile and less confident than usual. But outside of construction loans, money is still available for real estate. It's just a lot more cautious.

Pension fund investment in real estate will, in the aggregate, be cut back in 1991. But domestic funds are not out of the market. The large public pension plans, state funds in particular, are committed to real estate and are poised to act as soon as they perceive that volatility is reduced. Real estae as a percentage of assets for all pension funds will hold between 3.7 percent and 3.9 percent. That is way below the frequently quoted 10-percent goal. Trends evident during the last two years will intensify: withdrawals from commingled funds; focus on separate accounts and in some cases, direct investment; tougher scrutiny of advisor performance and more firing of managers.

Insurance company real estate problems will be more in the news. Real Estate Research Corporation's (RERC) survey indicates that bullet loans will come due in large volumes in 1992, 1993 and 1994. Refinancing or sale of these loans will be hard for some insurance companies but generalized fears of a major disaster are exaggerated. In fact, junk bonds and guaranteed investment contracts (GICs) are more pervasive problems for insurance companies, but real estate woes dominate media coverage.

Foreign investors will continue their retreat from new equality and debt deals. The emphasis here is on new. These investors will not exit the market nor will they abandon long-term commitments in U.S. real estate. Short-term concern about our economy's ability to handle its enormous debt; the recession; poor property performance; and better opportunities in Europe are good reasons to cut back. For Japan, their own banking and stock market problmes reinforce a sideline position.

Market outlook

While no one is enthusiastic about real estate prospects, there are areas of opportunity. Each asset type has different features, and to state the obvious, each locak market offers its own unique positives and negatives. From a macro, national perspective, RERC rates the land uses as follows: (1) industrial, (2) multifamily or (3) regional malls. There are reasons to be bullish in these asset types. We are less sanguine about smaller retail properties (especially power centers), suburban offices and hotels. Downtown office properties have to be looked at one by one.


Retail properties will, on balance, benefit from the tightening of capital markets. Fewer new projects in the pipeline mean less competition. On the other hand, the credit squeeze also hurts tenants, many of whom already have their backs to the wall. Consumer confidence is similarly affected and will translate into higher savings and less discretionary spending in 1991.

RERC is not bullish at all about smaller retail properties. There is plenty of this product--too much in most markets. Community and specialty centers face highly competitive environments because of overbuilding and because their mall tenants are vulnerable to an economic downturn. We are even more pessimistic about strip centers. New one pop up everywhere with a grocery store, a dry cleaner, two Chinese restaurants--and lots of empty space.

Regional malls, while still a preferred investment, aren't a sure bet. Demand for new space is shrinking, while leasing activity is slow and difficult. Department stores, generically, are in a complex transitional period. Their dilemma in sorting out what merchandise they can sell profitably, at what price points, is further complicated by management turmoil and extraordinary debt burdens. Still over the long haul, regional centers will retain their value and produce acceptable3 current income.

While demographic and economic reality do not support a lot of new retail, developers still focus on some opportunities.

Hypermarkets--These huge stores that combine grocery shopping with consumer items are still rolling out in major metropolitan areas. Surveys show that price is the prime reason people go to these stores. They're usually less convenient than the neighborhood Safeway or K mart, and they don't have the same depth of merchandise. Nor are hypermarkets the answer for busy shoppers who just want a few items. Further, the sheer size of these developments discourages the elderly.

Wholesale clubs--Wholesale clubs are still growing. Wal-Mart, K mart, Price Club and Costco are the big names. In 1990, there were 420 wholesale club stores, up from 360 in 1989. Look for more development of this concept. As a result, we'll see more trade-area encroachment, and by year-end 1991, competitive pressure will start to cut into what has been heretofore very strong financial performance of these stores.

Outlet malls--Factory outlet malls will continue to expand, despite the fact that some areas (New England in particular) don't need any more. The number of manufacturers with outlet stores shot up from 29 in 1982 to 190 last year. More and more upscale merchants and, particularly, manufacturers of designer labels, are going into outlet malls as a way to move surplus merchandise. They are also worried about shaky sales at department stores, and they see outlets as a hedge against those stores' financial problems.


Investors are losing some of their appetite for industrial property. That makes sense, with returns down, prices up and economic growth slowing. Modest but persistent upticks in vacancy are another cautionary note.

Despite that, RERC forecasts continued low capitalization rates for warehouse/distribution centers. This is the only asset class that commands prices higher than replacement cost. At a capitalization rate of 8 percent or under, their upside is being bid away.

At the same time, demand for warehouse/distribution space remains strong. We like the so-called "global gateway" locations that benefit from imports and exports. Transfer cities, airports, the Mexican border and ultimately Mexico itself are also strong markets. Some "build-to-suits" will prosper as large, corporate users consolidate in one, huge, exurban location. But there won't be new enough build-to-suits or sale leasebacks to support all the developers and investors who are counting on them.

More attention will also turn to industrial rehabilitation. To date, rehab has focused on large in-city properties. The next wave will be in well-located, suburban industrial parks that show their age. Environmental clean-up costs are the key constraint on the financial feasibility of industrial reuse.

Finally, small industrial users represent a large industrial demand segment. "Just-in-time" inventories and outsourcing by major manufacturers foster this market. Unfortunately, small tenants typically are not credit tenants, so this change in the user profile isn't positive for investors.


No fewer than 20 specialty apartment funds provided multifamily opotions for pension-plan investment as of mid-1990. That is a dramatic change from as recently as the early 1980s when institutional investors wouldn't touch apartments. Today, multifamily is at or near the top of institutional investor preference lists.

As a result, apartment prices are holding steady or rising. Capitalization rates are aggressive: 8 percent for quality properties and under that for some prized West Coast complexes. Many real estate organizations are holding back in the hope that prices will fall later in 1991 as distressed sellers are forced to the market. Our view is that with supply in check, and rents and occupancies climbing, prices will actually increase next year.

RERC has consistently advocated apartment ownership; and fundamentals for the 1990s are supportive of the view--with appropriate cautions. But with big money in the game, the pressure to acquire will accelerate, and supply and demand may take a back seat to funding this newly acceptable asset class. As the case for quality units heats up, it is drawing in more than institutional investors. Wealthy individuals and, increasingly, overseas investors are also attracted by the comparatively small price tags on apartments. A lot of the competition is for properties poised to respond quickly to market upturns--in Texas, for example, rents are increasing from month to month.


Office markets won't improve quickly. Outside of a handful of markets, such as Dallas and Houston, effective rents in office space are not expected to go up until 1993. A significant proportion of the real estate community think that it will take until mid-decade.

For 1991, demand for space is in decline. Overhangs are significant in most markets. Rents (net of commission) either are not moving or are moving down. Investors, once burned, are twice shy and are on the sidelines. Commercial banks aren't making many construction loans.

Analysts at RERC expect prices to be flat for the few high-quality downtown properties that sell. They will be down across-the-board for suburban properties. But, transactions will be few, as owners strive to maintain portfolio values by holding on. If a significant number of developers are literally forced to sell, prices could go down abruptly. More likely, banks and other lenders will take back projects and work them out themselves.

The play in the office asset class during the next year or two will be in cherry picking top-quality, well-located suburban product. These properties have taken a hit, in many cases deservedly so. Prices have fallen and will continue to fall into 1992. The lesson of the 1970s is especially true here: second and third owners of properties can do well after their predecessors have failed.


Hotel and motel properties are not high on most lists of real estate lending or investment preferences. There are good reasons for that: room rates are going up only at the rate of inflation (except in some super-luxury hotels), and in many cases, real average daily rates (ADRs) are declining. Meanwhile, occupancy is also down, and although you can point to special situations, such as Century City or Orlando, most markets are overbuilt. RERC expects nationwide occupancy to drop at least a point in 1991 and perhaps as much as 2 percent.

Painfully aware of domestic problems, American hotel operators are looking for action abroad, from Warsaw to Bangkok. At the same time, foreign investors continue to snap up domestic hotels and hotel chains. The most recent example is the purchase of Motel by Accor, a French lodging conglomerate that now manages 132,000 rooms in the United States. By comparison, Marriott manages about 110,000.

A lot of hotel product will come back to lenders in the early 1990s. There will be more and more bankruptcies, largely in smaller roadside and airport-oriented facilities that sprang up betwen 1981 and 1986. Takebacks in the form of deeds-in-lieu are also on the rise. Again, many projects were thrift-financed, tax-shelter-motivated and aren't making money.

As is the case with selected office projects, turning up as the second or third owner of a well-located hotel that needs a capita infusion for rehab may make sense in 1991. But 1992 will make even more sense, as lenders finally realize that a workout strategy is not feasible for these businesses.

On the horizon

A quick recovery in real estate is not in the offing. Most experts believe that markets won't turn around until the mid-1990s. Then, the recovery will have to be in rents. A pick up in real estate development and lending would be a disaster.

For those disposed to panic in the face of news reports of another developer or bank failure, it is important to remember that quality real estate is a long-hold investment. Ups and downs in prices, returns, values and markets should be expected even if they are not always welcomed. Changes in world events, monetary conditions and political affairs make everyone skittish. But real assets fare better than financial assets in tempestuous times.

Moreover, the structural changes now under way in the real estate business promise a stronger, more stable industy by mid-decade. That is not to say the transition will be easy--it will be fatal for many; painful for all. The human toll, in terms of jobs lost, will be enormous and can't be ignored. But there will be opportunities along the way for experienced professionals, and success, ultimately, for those who can afford to be patient.

Richard Kateley is president and chief executive of Real Estate Research Corporation (RERC), a national real estate advisory, consulting and valuation firm specializing in institutional analysis, portfolio and property evaluation, development feasibility and industry research.
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Title Annotation:real estate experts' views on what's in store for 1992 in the commercial real estate market
Author:Kately, Richard
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:Boardroom view.
Next Article:The rise and fall of the U.S. office market.

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