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Development niches in the Nineties.

Development Niches in the Nineties

Development opportunities in the 1990s will be fewer, and those searching for them will have to be more selective than in the past. But contrary to the dire forecasts that abound, there remain opportunities for firms who do their homework.

Demographics will change dramatically in the 1990s. A shrinking labor force, an increasing polarization of income and more pronounced geographic disparities will be evident as people and jobs flock to the West and to the Sunbelt. Developers will encounter more restrained financing, a tougher political and regulatory environment, and increasing tenant awareness and power.

These changes, many of which are already evident, won't facilitate development and may not ensure higher profit margins. However, the new decade will afford good opportunities for developers who are willing to acknowledge the wide-ranging changes in the real estate market, study their ramifications and capitalize on the outcome.

Demand dynamics

Demographic and socioeconomic fundamentals are probably the most important predictors of real estate activity - yet they are also inconsistent, contradictory and difficult to read. For example, we know that our population will grow more slowly but will become increasingly diverse. Household formations are expected to continue declining in the 1990s, totaling about 1.2 million a year throughout the decade, compared with an annual rate of 1.5 million in the 1980s and 1.7 million in the 1970s.

With a decline in population growth, we will witness the "middle-aging" of America, as the 80 million-plus baby boom generation shifts from the 30-to-45-year-old age bracket to the 40-to-55-year-old group. Also, the dramatic growth of non-traditional households will continue: aging singles living alone, unmarried couples cohabitating, single-parent households and married couples choosing to remain childless. The "traditional" nuclear family has become a minority - a trend that is likely to continue.

The number of elderly individuals is expected to continue to increase in the next decade. Concurrently, a decrease in the number of young people - both in absolute numbers and as a percentage of the total - is likely.

Finally, there will be tremendous growth in black, Asian, and, especially, Hispanic populations. By the year 2000, whites will be a minority in Los Angeles County; they already are in Chicago. By 2010, Hispanics will out-number African Americans in the United States.

As the population shifts, so will the labor market. Fewer young people will create a shortage of labor. In turn, this highly competitive labor market will spur an attendant increase in starting salaries. Regions located in the nation's midsection have already witnessed such events, as have retailers and hotel operators across the country. Notably, the composition of the work force is also in a state of flux. With 47 percent of today's labor force female, the era of the white male as the dominant presence in the work force is past.

Income concentration is yet another force that will affect all components of the real estate industry in the next decade. During the past 15 years, there has been only a slight increase in real income in this country. At the same time the number of affluent households has increased, as has the number of low-income households. The wealthiest 20 percent of Americans currently account for 40 percent of the nation's income - and that polar concentration of wealth will intensify. Therefore, as the number of wealthy and poor households continue to increase, the number of middle-class households will diminish. This shrinking of the middle class is also evidenced by the development patterns of retail stores - Bloomingdale's at one end; K-mart at the other - as well as in housing development. The shrinkage of the middle market and the subsequent bifurcation - if not polarization - of consumers will be even more apparent in the future.

These changes in population, income and employment won't be evenly spread across the country - most demographers and labor economists foresee a bicoastal pattern of movement during the next century. People and jobs will be disproportionately tilted in favor of the West and the Sunbelt. California, Texas and Florida will reap gains at the expense of the rest of the nation.

In a nutshell, the 1990s will be vastly different from the past two decades. There will be no automatic growth and no mass market. The middle market will decline. Ethnic diversity will intensify. We'll see a multiplicity of smaller, segmented, specialized consumer groups.

Does this spell disaster for the real estate industry? No, actually not. It spells opportunity. The opportunities of the 1990s may not be in plain sight, but they exist. It is up to savvy developers to study their markets and capitalize on local niches.

Custom-made markets

These fundamental changes require that real estate developers, aiming to match product to tenants, to take a much harder look at micro-market conditions. An analysis of local user preferences in micromarkets, rather than broad national profiles, will be required to accurately predict tenant demand for office space and industrial uses as well as for retail and housing. In an increasingly consumer-driven market, real estate developers will have to diligently play matchmaker, sizing up tenants' needs with suitable projects.

A consumer- or user-driven market also means more intensified direct consumer and tenant research. Aggregate census categories, macro employment figures, or Standard Industrial Classification codes won't provide the details needed to forecast business choices, retail patterns or household behavior in the coming years. In this new age, surveys, focus groups and polling will be the tools used to identify and document consumer demand.

Finally, product differentiation will afford an opportunity for many developers to capture a niche market. The 1990s will not be a time of "one size fits all." Custom-designed projects, carefully matched to meet microeconomic needs hold promise for the new decade.

Financing and capital

Just as developers are going to have to search out opportunity, they will also have to look hard to locate financing. Despite the fact that the world is literally flooded with funds for debt and equity, the question remains as to how enthusiastic potential financiers will react to United States real estate generally, and certain development deals in particular.

Recently, institutional investments into equity, short-and long-term debt, and hybrid investments have been mediocre, at best. Real returns have been hardly better than 10-year Treasuries, and spreads of less than 250 basis points clearly indicate that real estate's risk premium has been bid away.

Values are flat in most portfolios and point downward in others. In addition, there is increasing concern that in overbuilt markets, real property yields will not hedge an inflationary uptick. Therefore, returns may be less stable than what the industry once relied upon.

As a result, institutions will become - if they aren't already - much more selective. Although there are plenty of sources, investments are targeted to a very narrow segment of development projects. While there is lots of talk about niche investments and higher-risk properties, by and large, it's just that - talk.

Real estate finance will experience major deleveraging in all markets. The U.S. is the only country in the world to rely so heavily on debt - from individual home mortgages to leveraged buyouts of major corporations.

Another characteristic of the industry during the next 10 years will be the globalized financial markets leading to the increased use of equity financing. Developers will have to back themselves with much of their own money. Strong balance sheets - with a solid asset base (not last year's half-leased building) - will be the norm. Cash - real, current return - will be king.

Construction lenders will be fewer. Those that remain will become much more conservative. With many S&Ls gone, and U.S. money center banks on the sidelines, off-shore banks have stepped up their construction lending. It's probable, however, that these new entrants won't want to take on the added risk of construction loans for too long.

With the number of construction lenders already dwindling, it has become harder to find take-outs and construction loans for smaller projects. Looking ahead, this will be particularly true of apartment, small office and strip retail deals.

It's important to keep in mind, however, that the drying up of construction funds is a short-term phenomenon. The last thing that is needed now is a lot of marginal or poor product, but good real estate can always find financing.

Regulatory grip

As lenders and developers enter this last decade of the century, they will see the further emergence of controls on growth. This grip-hold on growth will produce higher impact fees and increased environmental risks and liabilities.

Although developer fees and growth controls are required by local governments to foot the bill for essential infrastructure, it's also a fact that institutional investors, foreign and domestic, support policies that constrain supply. Count on that critical half of the industry to push growth limits, impact fees and higher financial hurdles for new projects.

Power tenants

Yet another big change in the 1990s will be tenants' growing awareness of their power. Historically, developers, lenders and investors have subsidized corporate America's space use. Developers have provided high-quality space, with extravagant amenities, without obtaining rents commensurate with the cost - not to mention a return on the risks of those projects. Increasingly, the investment community will view commercial real estate deals in terms of the value of the leases. In the future, institutional investors - specifically the insurance companies and pension fund advisors - will begin dealing directly with tenants. They will try to bypass developers by doing build-to-suits and by forming joint ventures with major users. Tenants will use this clout to a far greater extent than they did in the 1980s. This will, at least for the first half of the decade, work against developers. Developers will fight back, but there will be formidable competition from institutions for new projects in the later years of the 1990s, when markets again reach equilibrium.

As these individual trends - a shift toward segmented, consumer-based markets; the deleveraging of finance; intensified political/regulatory pressures; the ascendancy of power tenants - play themselves out, the structure of our industry will look quite different. In many ways, it already does. The downsizing and consolidation that have occurred during the past two years will continue, at least for a while. Larger firms will get larger and more dominant, smaller ones will stand pat or go under and middle-sized operations will get squeezed - many of which will go out of business.

As the interests of the development community and the institutional investment community diverge, we will see much more of a split between builder/developers and investor/owners. It is already obvious in the area of growth controls. And, some large investment entities will muscle developers out of big-ticket, tenant-driven deals.

The required adjustment between the mismatched large, internationally funded, institutional players desiring big, conservative projects and the market demands for smaller, local, specialized real estate best suited to local or regional developers will, in the short term, be painful. Some good projects won't get financed. Some developers and financial institutions will bite the dust. Meanwhile, the low-return megadeals will get the go-ahead because institutional players are more comfortable and secure with projects that involve those familiar risks.

Managing the market

Markets that grow modestly overall, and become more specialized, will support firms that seek market share by expanding in one or more existing areas of strength, or by branching into related products or businesses.

The capital structures of the 1990s, especially the deleveraging of business in general, will place much greater emphasis on company operations and operating skills. Making money in the core business has to be the focus when firms are required to finance expansion out of current earnings - not out of debt. So, just as asset management is the key to maintaining and enhancing property values, operating talent inside development firms will be key to an institution's success.

The political/regulatory environment of the new decade promises longer development horizons and higher development costs. That suggests that controlling land will be a major determinant of successful growth. In a business where development approvals and entitlements - along with cash - are king, political staying power will emerge as important as financial strength.

Finally, real estate development is fundamentally a "people" business, and operating talent and management skills will be at a premium. Large firms have no monopoly on talent. Developers must be responsive, flexible and adaptable, and must invest time and money on people, not deals.

Management talent, in my view, will be the real upside for our industry in the 1990s. The amateurs are gone. The people that remain in our business now are knowledgeable, experienced and professional. And that advantage is more than equal to the problems our industry may face during the next few years.

Richard Kateley is president and CEO of Real Estate Research Corporation, a nationwide valuation and consulting firm. The 60-year-old Chicago-based company maintains offices in New York, San Francisco and Washington, D.C.
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:future demographics of the mortgage market
Author:Kateley, Richard
Publication:Mortgage Banking
Article Type:Cover Story
Date:Sep 1, 1990
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