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The Fed, Congress to determine industry's recovery.

Job creation, economic growth and interest rate volatility in 1995 will have a tremendous impact on the rate of continued recovery for the nation's real estate industry, according to the National Real Estate Practice of KPMG Peat Marwick LLP.

While the industry has shown marked improvement in nearly all sectors of the market in 1994 and continues to do so in the first months of 1995, several upticks in interest rates and the uncertainty of the country's new Republican legislative agenda, have combined to send out a potential warning signal as we head into 1995.

"There is no doubt that the industry has begun to come into balance after several years of instability," said Roger Johnson, national director of KPMG Peat Marwick LLP's National Real Estate Practice. "Overall, with the exception of a few storm clouds in the real estate capital markets, we can look ahead to sunny skies for the real estate industry in the new year."

"However, going forward, the chance of a full-blown recovery lies greatly in the hands of our new Congress and the Fed's actions on interest rates and other market issues," Johnson continued. "The rules for a new game are still being written and, at the least, the industry must proceed with caution if it is to continue its favorable recovery."

"Job creation remains the key to the continued recovery of the real estate industry," added Johnson. "There is no getting around the need for a return to fundamentals if the industry is to ever emerge from the '80s catastrophe."

Infrastructure a Key

Johnson also noted that the chronic need to rebuild infrastructure will be an issue for years, as it affects a city's ability to attract people and jobs. Cities that can support a commuter transit system, an integrated ground and air transportation web and increased stress on utilities - while balancing public resistance to more municipal bond financings - will be able to attract business and sustain job growth.

Johnson foresees the southeast and southwest regions of the country being the big winners, experiencing an increase in job growth and economic development, because of the population growth predicted in these areas for 1995.

Implications of a Republican Congress

The Republican Party's "Contract with America," if passed it its current form, could benefit the real estate industry, according to KPMG Peat Marwick LLP's National Real Estate Tax Practice. However, the path to enactment is not without obstacles, the Practice warns.

"Changes could be made which would result in less favorable or even down-right adverse tax results for the real estate industry," said Philip J. Wiesner, national director of Real Estate Tax Services.

The Contract's "Job Creation and Wage Enhancement Act" contains two key provisions that could affect the real estate industry - "Capital Gains Reform" and "Neutral Cost Recovery."

The proposed "Capital Gains Reform" would provide individuals and corporations with a 50 percent deduction for capital gains and an inflation adjustment to the basis of capital assets. Also provided would be a deduction for any capital loss incurred on the sale or exchange of a principal residence.

"If the past is any indicator, one key battleground will be the amount of tax depreciation claimed with respect to real estate assets that may be subject to 'recapture' as ordinary income and, therefore, not benefit from capital gains treatment," Wiesner said.

"Neutral Cost Recovery," the second key provision impacting the real estate industry, would introduce a new depreciation system for all assets, including real estate. According to Wiesner, the objective of this provision is to make the present value of tax depreciation the same as if the property were immediately written off for tax purposes in the year of its acquisition.

"It's safe to say that the industry will never again be allowed the rapid write-offs granted in 1981, when the depreciable life of real estate was 15 years. The tax depreciable life of most real estate is currently 39 years and resistance can be anticipated to any attempt to substantially shorter, it," Wiesner said.

"The Republicans are promising a somewhat conflicting agenda of fewer taxes and budget reduction, so the big question remains where the cuts will take place," Wiesner said. "Because there appear to be areas that are off-limits, such as Social Security, Medicaid and Medicare, the Republican-controlled Congress may be tempted to reduce some current tax deductions in order to reduce the extent of the budget cuts."

"If Congress were to be so tempted, those with an interest in real estate should remember that deductions for home mortgage interest and for real estate taxes are two of the largest so-called tax expenditures," Wiesner said. "Thus, the real estate industry should be wary when Congress is looking for revenue to offset its proposed tax cuts or if the push for flat tax truly gains momentum."

Interest Rate volatility Dampens Real Estate Capital Markets Activity

Banks, thrifts and insurance companies withdrew from the real estate markets in the late 1980s and early 1990s. Owners and developers increasingly looked to Wall Street as another, more stable source of capital. Securitization hit an all time high of $20 billion last year and it continues to mature as investors become more familiar with the product.

After seven recent interest rate increases and the return in 1994 of traditional lenders who revamped their underwriting procedures, the flow of real estate into the capital markets has cooled. "That is especially true as it relates to the growth of conduits," said Charles R. Walker, a partner in KPMG's Real Estate Capital Strategies Group.

"I'll cite two reasons: When you add the cost of securitization to the trading levels of commercial mortgage-backed securities, the capital markets alternative may not be able to compete with the returning traditional portfolio lenders - the spreads just may not work," said Walker. "Secondly, recent isolated defaults in securities, such as the Ginsberg multi-family transaction, have toned down investors' enthusiasm."

"Better, more complete information regarding the ongoing performance of the underlying mortgages - the collateral for the securities - is vital," he said. "Investors will demand it. And the issues that cannot, or will not, provide such information will suffer where it hurts most - in their trading prices."

Despite slowed securitization volume and activity in recent months, accessing the capital markets through securitization is here to stay, reports the practice, and will continue to be a major option in the mix of real estate investments because favorable investor returns drive it.

Walker concluded that because commercial mortgage-backed securities hold the largest potential for infusing capital into the real estate industry, "More long-term securitization - over time - will be used increasingly by traditional lenders as an additional avenue to help their loan portfolios become more fluid, more agile in volatile market conditions."

Return of the Traditional Lender

For the most part, the end of 1994 marked the return of traditional sources of real estate financing for all segments of the market. Capital is flowing and banks, insurance companies and pension funds are investing or lending in the real estate market once again, albeit much more conservatively, according to KPMG.

"Far-sighted insurance company lenders have returned to the market and large pension funds have come back into the direct real estate investment business competing for ownership," said Paul Reilly, national partner-in-charge of Financial Services Consulting. "As we move into 1995, we can expect these investors, who were on the sidelines last year, to increase their role in the $3 trillion real estate market, now viewed as an inflation hedge with double-digit returns expected and little downside risk."

In search of higher yield and diversification, banks, insurance companies and pension funds will grow more active in the real estate industry, which is currently showing potential for superior returns over the stock and bond markets, a trend that is likely to continue, Reilly predicts.

Perilous REIT Market Filled With Opportunity

"For the past three years, REITs, or real estate investment trusts, have been the headline maker, the market darling," said Johnson. "But looking ahead, the REIT market is on the verge of a substantial shakeout. Interest rate volatility combined with the bidding up of prices and market saturation over the past few months has resulted in both an increasing number of REIT IPOs of less than stellar quality, as well as a significant decline in activity."

As a result, the market is punishing the pricing on those REITs rocked by yields that fail to keep pace with returns from other, less risky, less interest rate-sensitive securities, he added.

"The thing to watch for in 1995 will be the REITs' ability to meet the dividend payout projected at the time of the initial offering," said Johnson. "If they fail, the market will punish the share prices severely and it will trigger a major consolidation movement and a multitude of takeovers in the REIT market, as we have already witnessed on a very small scale."

Multi-family REITs, last year's hottest ticket, have reduced their appetite for acquisitions because of the increased cost of debt and equity capital. One arena to watch for initial public offerings, though, is the industrial segment, reports the practice.

Opportunity for Foreign Investment Continues

While foreign investors are skittish about U.S. real estate in the short-term, partly because of volatile interest rates, the practice predicts the industry wilt continue to become a more global enterprise, with both U.S companies investing abroad and foreign ventures coming into the U.S.

"Foreign sites such as Mexico, China, the Pacific Rim, Russia and Eastern Europe continue to offer major real estate investment opportunities," said Paul Garity, national director of real estate consulting. "As globalization continues, these areas need hotels, offices and apartments that meet Western standards in order to compete. The challenge for U.S. developers is to find locally-based partners to navigate the politics and international lenders for financing," said Garity.

Also, there may be some opportunity in Europe for vulture funds to buy non-performing real estate loans from foreign equivalents of the RTC, as is currently happening in Sweden, noted Garity.

According to the practice, foreign investment in the United States is expected to increase, first from Europeans seeking higher returns, and then from Asian flight capital. One growing area of opportunity for foreigners is to purchase REIT shares to obtain higher yields without sacrificing liquidity as they have in the past with direct investments.

1995 Outlook for Construction

"Contractors are optimistic about the economic prospects for 1995, as evidenced by their projections for continued growth in business volume," said John Callan, national director of KPMG Peat Marwick's Construction Practice.

According to a survey of financial managers conducted by KPMG Peat Marwick for the Construction Financial Management Association, nearly two-thirds (64 percent) of those surveyed expect an increase in next year's volume, compared to 56 percent the previous year and 47 percent in 1992. Single family/residential and industrial/nonresidential segments are the most optimistic, with 73 percent and 72 percent, respectively, expected in increased volume in 1995.

In addition, more than three-quarters (78 percent) of those surveyed indicated their company's availability of credit has improved over the past 12 months, a signal that the economy is moving out of recession, according to the practice.

"The availability of credit is a good signal that the economy is recovering, which should translate into more activity for the industry," Callan predicts. "The coming year should be a good one for the construction industry if the projections of those surveyed are any indication."

While we will most likely see construction in the residential and the economy segment of the hospitality industry, the picture for construction is not all roses. Opportunities for development in the office market remain grim, according to the practice. "Speculative office development is unlikely in most markets since the country has about a ten year supply of office space available," said Garity.

"If there are any office development opportunities to be had, they will be found by following tenants who may venture into smaller cities that offer low-cost housing and special incentives," Garity said.

Strengthening Office Market Not Enough to Calm Investor Apprehension

Rising rents, increasing occupancies and the reduction of concessions in almost all office markets across the country has not been enough to put investors' apprehensions to rest, according to the practice.

"Overall office market vacancies will continue to decrease to the 15 to 17 percent level, down from 18 to 20 percent in many markets," Johnson said. "But values are lagging behind due to a lack of investor confidence and fears of interest rate increases." He also clarified that few of the five million jobs created over the past two years have been for users of Class A office space.

"Additionally, investors are still skittish due to uncertainty over continued corporate downsizing, telecommuting and the sharing of office space, as well as general uncertainty about the strength and duration of the overall recovery," he said. "The bottom line is companies are learning to do more with less, decreasing the demand for commercial office space, particularly in central business districts."

However, according to the practice, it appears that the suburban office market is recovering more quickly than the downtown space in most cities. "Corporate America loves the convenience and quality of the suburban market," said Garity.

The practice points out that some cities are faring better that others in the office market recovery. For example, downtown Los Angeles is so bad it can only go up, while cities such as Washington D.C. and San Francisco lave done better because of continued job growth and restrictions on new construction.

"Despite low property values in 1995, we'll witness the sale of more troubled office buildings, which will finally be sold by insurance companies and Japanese banks who had foreclosed and waited for a fast and strong office recovery that just did not happen," Garity said.

Residential Markets Post Record Year

The practice reports that 1994 was a record year for the single family housing market. "Historically low interest rites at the beginning of last year and improved employment figures fueled the demand in the first-time home buying market as it put pressure on people to get out of apartments and multi-family dwellings," maid Garity. "Irresistibly low interest rates also made significant new construction possible for current homeowners looking to trade up.

"With every point that interest rates increase, 500,000 individuals lose the ability to afford a house," maid Garity. "Therefore, if rates stabilize at current levels there is an excellent chance that we will continue to see exceptional activity, including additional new construction in the housing market. However, if rates continue to climb, housing staffs are likely to level off for a while and then slow way down."

The practice also reports that apartment values lave now peaked and further significant appreciation in this segment is not expected in the near future.

"With a strong increase in earnings, occupancies and room rates in most major U.S. markets in 1994, the hospitality and lodging industry continues to show signs of substantially improved performance at all price points and at a pace much faster than was predicted," said Frank Nardozza, national hospitality industry director. "Hotel values increased 18 percent in 1994."

"Although the hospitality industry may be the fastest segment to climb out of real estate disaster, let's not forget that it was also the hardest hit," said Nardozza.

"The window of opportunity for 'bargain basement' buying is expected to close in 1995 due to escalating hotel values and a robust hotel deal market," warns Nardozza.

"Faced with rising interest rates and climbing hotel values due to improved earnings and a downward adjustment on capitalization rates, investors are operating within a seller's market," he added.

If interest rates and hotel values continue to heat up, those investors with access to Wall Street funding, such as large real estate investment funds and hotel companies, will continue to dominate the hotel property acquisition market in 1995. The practice also points out that investors from the Middle East and Asia continue to actively pursue institutional-grade hotels and hotel portfolios throughout the U.S., with luxury properties a target in key U.S. cities such as Chicago, New York and Los Angeles.

"Increased trade and travel as a result of NAFTA and GATT will also spur greater lodging demand and investment opportunities for international hotel companies - and this may be only the beginning," said Nardozza. With a free trade zone for the Americas looming on the horizon, opportunities will consequently continue to expand, he noted.

The Summit of the Americas, held in Miami in December, set the framework for the establishment of a $13 trillion trading block for the Americas, which would far outweigh the European Community in size and clout. "Savvy investors should begin taking steps now to expend market distribution throughout the Americas," Nardozza said.

"Due to increasing interest rate pressure and a full plate of transactions committed at year-end 1994 by institutional investors, who essentially make the market for hotel REIT offerings, the flood of new offerings was cut book to nothing but a trickle," added Nardozza. "It is likely that several of the postponed issues will come to market in early 1995, but at slightly higher yields to meet tougher investor return requirements."

"Banks, insurance companies and credit companies are likely to re-emerge as primary sources of hotel financing; however, be forewarned because underwriting criteria will be significantly tougher than that of the 1980s," maid Reilly.

Unfortunately, mortgage conduits, believed to be one of the hottest financing products in the mortgage-backed securities market at one time, have yet to take hold as a major new financing source for hospitality ventures. With interest rates 300 to 500 basis points above mid-term T-bill rates, conduits are too expensive for most borrowers, he explained.

"Unless interest rates decline in 1995, or the programs are redesigned to be more affordable to borrowers, the practice does not expect conduits to take hold this year either." Reilly warned.
COPYRIGHT 1995 Hagedorn Publication
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Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:real estate business
Publication:Real Estate Weekly
Article Type:Industry Overview
Date:Mar 22, 1995
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