For years commercial real estate investors and developers have been trying to get closer to public capital sources. Well, 1998 will be remembered as the year that Main Street real estate markets collided head on with Wall Street capital markets.

And the result - at least in the short-term - wasn't the kind of market stability and access to cheap capital most real estate players had in mind.

A shakeout in world capital markets fueled by worries about economic downturns in Asia and Russia, combined with concerns about an overheated real estate market at home in America, caused Wall Street debt and equity markets to do a flip-flop during 1998.

"In the last five years, the real estate industry like the rest of corporate America eyeing future growth and profitability, has wished for a global market," says real estate sage Stan Ross of E&Y Kenneth Leventhal. "In 1998, we got that global market. Now we have to live with its ups and downs."

After starting 1998 with record company mergers and high-priced property acquisitions, real estate investment trusts ended the year sidelined by falling stock prices and analysts' concerns about too much construction.

At the same time, the flow of public debt to real estate investors and developers went from a flood early in the year to just a trickle by the start of 1999.

The whipsaw in public real estate sector conditions left many experienced property players with a head spin. But savvy Wall Street observers say this kind of volatility is part of the game.

"It was a surprise to the people on the real estate side - their first exposure to one of these shifts," says Michael Jungman in the New York office of J.P. Morgan. "Over the past four or five years, you have had this increasing interconnection between the world of real estate and capital markts."

No wonder 1998 seemed like two completely different worlds for commercial real estate. Early in the year, all the headlines were about property buys and big company mergers.

The biggest building in North America -- Chicago's Sears Tower -- sold for almost $850 million to investor TrizecHahn Corp. The acquisition was one of several major purchases by the public real estate company of major office properties across the country. At the same time, TrizecHahn was arranging the sale of its shopping mall portfolio (which closed in December) for almost $2.5 billion to Los Angeles-based Westfield America Inc. and Maryland-based Rouse Co.

Also in the first quarter of 1998, a joint venture of PaineWebber Real Estate Securities, Morgan Stanley Real Estate Funds and Gale & Wentworth LLC completed a purchase of interests in 54 office buildings from Bellemead Development Corp., a subsidiary of The Chubb Corp. The portfolio included 7 million sq. ft. of office properties located mostly in the Northeast.

In another big acquisition, San Mateo, Calif.-based Glenborough Realty Trust Inc. agreed to acquire 15 office and industrial properties for $474 million from two different buyers. The REIT's acquisitions totaled almost 4 million sq. ft.

But the big real estate news on Wall Street early last year wasn't just individual buys as much as public real estate company mergers and acquisitions.

Indianapolis-based Simon Debartolo Group beat out competitors including the Rouse Co. and Vornado Realty Trust with a $5.8 billion deal to buy CPI. Among CPI's regional mall holdings were the 1.4 million sq. ft. Lenox Square in Atlanta, the 1.35 million sq.ft. Metrocenter in Phoenix and the 1.6 million sq. ft. South Shore Plaza in Braintree, Mass.

Raleigh, N.C.-based Highwoods Properties Inc. agreed to merge with Kansas City-based shopping center firm J.C. Nichols Co. in a transaction valued at $570 million. J.C. Nichols, founded in 1905, is best known for owning the Country Club Plaza shopping center in Kansas City.

Meanwhile, San Francisco's AMB Property Corp. formed a REIT. With $2.2 billion in assets, the industrial and retail center owner became one of the country's largest public real estate companies.

Even bigger deals in the early months of 1998 were announced and completed among hotel companies. Last January Patriot American Hospitality Inc. and Wyndham International completed their merger. Cleveland-based Boykin Lodging Co. has agreed to acquire Phoenix-based Red Lion Inns Limited Partnership. CapStar Hotel Co. paid $150 million for New York-based Medallion Hotel's property portfolio in Texas, Oklahoma and Kentucky. And Bristol Hotels & Resorts of Dallas agreed to acquire 20 Midwestern hotels in a merger with privately owned Omaha Hotel Inc.

Also in the first quarter of last year, Phoenix-based Starwood Hotels & Resorts Trust and Starwood Hotels & Resorts Worldwide Inc. entered agreements to acquire four luxury properties for $334 million, including the 257-room ITT Sheraton Luxury Collection Hotel in Aspen, Colo., and the 214-room ITT Sheraton Luxury Collection Hotel in New York.

In hindsight, Wall Street analysts say the frenzied pace of deals in early 1998 should have been a tip off that the market was overheating.

"We couldn't have gotten more winks and nudges and we ignored them," says Joseph Rubin in E&Y Kenneth Leventhal's New York office. "We were in a euphoria at the start of 1998 and the markets were at such huge volumes."

While stock prices for real estate investment trusts had already begun to decline from recent highs, in 1998's second quarter the big deals continued to hit the market.

Greenville, S.C.-based Insignia Financial Group agreed to sell its national residential operations and 75% interest in its Insignia Properties Trust to Denver-based Apartment Investment and Management Co. (AIMCO) in a deal valued at more than $900 million.

Also in the second quarter, Chicago-based General Growth Properties Inc. agreed to spend $625 million to buy U.S. Prime Property Inc., a private real estate investment trust managed by ERE Yarmouth Inc. At about the same time, General Growth had bought eight regional shopping centers from MEPC Plc for $871 million.

Baltimore-based Prime Retail received a $305 million loan from Nomura Asset Capital Corp. to buy competing outlet center developer Horizon Group in a deal valued at $973 million.

REITs continued to pay near-record prices for individual office and hotel properties. In may, Boston Properties Inc. agreed to spend a staggering $1.2 billion for the huge Embarcadero Center mixed-use complex in downtown San Francisco. The purchase included four office towers and shopping center space.

Equity Office Properties Trust of Chicago purchased the 32-story, mixed-use 100 Summer Street building in Boston's financial district for $108.5 million. And Equity Office paid $90 million for two office buildings in San Francisco's financial district - the 301 Howard building and the former Del Monte headquarters.

The hotel companies also were on a growth spree in the second quarter. Washington, D.C.-based Marriott International purchased the remaining 51% interest in Atlanta-based Ritz-Carlton Hotel Co. for $200 million.

"1998 was a real roller coaster of a year," says John Kukral with New York-based Blackstone Group. "At first, the public markets were driving prices up to unrealistic levels."

But since the REIT price shake out credit crunch that began in late summer, prices fell 10 to 20% on properties and, "People's anticipation of the future and how quickly things will grow has been brought back in to focus," Kukral says.

Early in 1998 private investor Blackstone Group put all of its commercial properties on the market expecting quick sales to eager-beaver REITs.

"We tried to sell close to $4 billion in properties, and we ended up getting rid of about $3.3 billion," Kukral says. "At the beginning of the year, all the buyers were REITs."

But the market was changing. Blackstone's office portfolio which wasn't put up for sale in March wound up going to multiple buyers.

"We ended up trying to sell them to more than a dozen buyers - some REITs and some to private buyers," Kukral says.

After a strong market for acquisitions and double-digit returns in 1997, public real estate companies were expecting another good year throughout 1998.

But investors' worries that REITs were overreaching to do deals began to impact stock prices in the spring and summer. Cut off from continued sales of hi gh-priced stocks, REITs began to pull back from making further acquisitions.

"The period of deal making shifted on a dime and those kinds of activities slowed down and became more cautious," says Goldman Sachs managing director Mark Tercek. "The public stock market anticipated in early-1998 that things weren't going to be as good going forward," he says.

Still, investment advisers and Wall Street debt and security analysts say some of the public-sector deals done in the first half of 1998 will set new benchmarks for the industry.

"Some of these assets just don't turn over that often," says managing director Michael Higgins with CIBC World Markets. "Logically, some people who bought at the highest point of the market may feel like they got stuck."

"But if you are in the business for the long term, good financial structure is the most important thing," Higgins says.

Even so, by the third quarter of 1998 the number of public-sector transactions was declining. The largest deals were done in the summer.

New York-based New Plan Realty Trust and San Diego-based Excel Realty Trust Inc. signed a merger agreement creating the largest community and neighborhood shopping center REIT, with $3.5 billion in total market capitalization.

Equity Residential of Chicago inked a deal to buy Merry Land & Investment Co. Inc. of Augusta, Ga. The merger was valued at more than $1 billion.

Trammell Crow Co. of Dallas, which had already acquired the brokerage firms Doppelt & Co. and Fallon Hines & O'Connor, announced in July it was buying the assets of Charlotte, N.C.-based Faison & Associates Inc. for $39.1 million.

And Dallas-based Bristol Hotel Co. formed the largest independent hotel operating company in North America in a deal with FelCor Lodging Trust.

Bristol spun off its non-real estate assets into a new public company called Bristol Hotels & Resorts. At the same time, FelCor Lodging Trust acquired the real estate assets of Bristol Hotel Co. through a merger.

But even the slowdown in REIT buys and falling stock prices didn't prepare the commercial real estate industry for the credit crunch that hit in October.

Questions about underwriting and high property values put the commercial mortgage-backed securities market in the tank and sent other lenders running from new spec development.

The early October bankruptcy filing by Maryland-based commercial mortgage company Criimi Mae Inc. added to the turmoil in the debt markets.

"The CMBS market went through nine months of watching the REIT market collapse and they did nothing," says E&Y Kenneth Leventhal's Rubin.

"They didn't they think there was some relation there, but as soon as everybody thought in 1998 we might have hit the peak, the capital markets said, 'I'm out of here,'" he says.

CMBS firms were left holding portfolios of unsold loans. Traditional lenders jumped out of the market to evaluate their underwriting. And investors and developers looking for high-leverage debt were left without many choices.

Lenders and borrowers both say it was the speed of the debt market switch more than the severity of the credit crunch that caused the biggest disruptions in their business.

"The borrower was thinking things hadn't changed for them," says Richard (Dick) Gunthel, who heads the real estate department at BT Alex. Brown. "A lot of the buyers of the (CMBS) product had been some of the hedge funds," says Gunthel. "And the hedge funds were particularly hard hit by losses in international markets."

Gunthel adds that "when they lost their liquidity, they had to sell the assets that were the most liquid, and once they started throwing assets overboard, that put pressure on, and people started calling for mark to markets."

Some of the biggest financial firms were caught off guard.

"Anyone who says we should have seen this coming are way off base," says Robert Lutz, chief executive of Dallas-based financial services firm AMRESCO Inc. "I talked to some people who had been in business for 30 years and werecompletely blindsided."

AMRESCO and other firms were forced to sell off the portfolios of loans they had targeted for the CMBS market and suffered losses. Some of those companies still have not returned to the public debt market. Others like New York-based Capital America, have suspended operations altogether.

"We have exited the securitization business," says Lutz. "The irony of that is that it could be in the face of what might be the most profitable time for it."

Wall Street analysts say the CMBS market is already beginning to recover. But with tougher underwriting and smaller volumes, the business this year won't be what it was in early 1998.

"Debt investors have been sharpening their pencils," says John Kriz, an analyst with rating agency Moody's Investors Service. "They feel at this point in the market it's important to hold paper for companies they believe will not only survive this quiet time but will prosper when things pick up."

And even then, analysts say don't soon expect to see the kind of public debt market that existed in early 1998.

"What we are going to see in 1999 is smaller transactions and a trend toward creating a branded contributor ? someone investors can get comfortable with," says Joe Franzetti with Duff & Phelps Credit Rating Co. "Last year, everybody wanted to have the largest pool (of mortgages) they could get their hands on."

Well, that turned out not to be the best approach. "Now lenders are taking a cautious approach to commercial mortgage-backed securities," adds Franzetti. "They have tightened up their pricing and are focusing on their underwriting."

Long term, Franzetti says public debt sources will continue to be the cheapest sources of capital. Capital was in short supply for REITs by the end of the year. Cut off from new securities sales, most companies backed off new acquisitions and tried to preserve their capital.

Some deals that closed were retraded with new terms or prices. In December, Crescent Real Estate Equities Co. of Fort Worth and Reckson Associates Realty of New York announced that they had changed the terms of their purchase of New York's Tower Realty Trust.

The value of the deal was cut from about $734 million to $690 million. And Crescent sharply reduced its contribution to the deal. Following Starwood Hotels & Resorts' fourth quarter conversion from a REIT to a standard, tax-paying C-corporation, there have been predictions that other REITs might give up their special tax status.

But analysts and REIT industry members say the best companies are sticking with their long-term growth plans through the current down time.

"Most of our clients already saw there were signs of overdoing it in the real estate market and they were already slowing down their activities," says Goldman Sachs' Tercek. "Some of the public REITs who have consistently performed for their shareholders have fared better in these difficult capital markets."

Likewise, weaker competitors are being more heavily penalized.

"I think capital will be made available for strong players and for smart transactions," says Tercek. "It will be less available for weaker players."

Most analysts think the worst is over for REIT stock prices, which dropped more than 25% in 1998.

"There is a true disconnect between what is going on in the real estate market and the stock prices," says Mark Patterson with Salomon Smith Barney. "That should not last. I think over a very short period of time it will begin to correct itself."

REIT managers are spending the early months of 1999 trying to find out where they are in terms of recovery.

"As we enter 1999, the questions on everyones' minds are, 'Did we have the correction in stock prices in 1998? and, 'Are we now poised to regain that momentum,'" says Steve Wechsler, president and chief executive of the Washington, D.C.-based National Association of Real Estate Investment Trusts (NAREIT). "The curious part of 1998 was we saw both retrenchment in capital markets and stock prices at a time when the fundamentals looked strong."

Many securities analysts and real estate economists say that the shake up in the public real estate markets will help the industry on the short term and the credit crunch was warranted.

"The public markets were looking at the REITs saying, 'We don't like what's happening in real estate and we are going to knock your prices down,'" says Bill Maher, director of strategic research in LaSalle Advisory Capital Management's Baltimore office. "That's good news - it will anticipate and adjust so the underlying real estate markets will have stability."

By slowing new speculative construction and pulling sales prices back from recent records, Maher and others hope to prolong the current real estate cycle and keep property returns positive.

"During the current lull, REIT managers will have to focus on maximizing returns without a flood of new acquisitions or development," says Mark Decker, formerly an investment banker at Friedman, Billings, & Ramsey of Arlington, Va. "We have unquestionably a lot of seasoned real estate investors in this market."

The REITs are in an interesting box right now. They can't raise equity cap because they cant sell stock with prices where they are. REITs still have access to capital, but it's restricted.

"But it wouldn't surprise me to see this lull go longer than the 10-month lull we saw in 1994," says Decker. "Even so, we could see a bounce-back in the third or fourth quarter. The industry is poised for a very significant growth cycle and there is tremendous value in the REIT companies."

For private investors, the slowdown in public real estate activity is providing a new window of opportunity. Many U.S. institutional and foreign buyers that were priced out of the investment market early in 1998 in the flurry of REIT buys are now back shopping for income property deals.

Some of the largest recent transactions have been to non-REIT buyers - for instance, the $325 million sale of the 72-story NationsBank Plaza tower in Dallas to a group of European investors represented by Sunbelt Management of FLorida. And Atlanta's Cousins Properties Inc. at the end of 1998 sold $284 million worth of existing and planned properties to a group of Prudential Insurance Co. of America clients.

"We are actively in the market for properties and we're moving up the quality curve," says Andy Tedford with private investor New York-based Westbrook Partners. "There is now a more sizable requirement for equity in the market and that's creating more opportunity for us."

One remaining hurdle is getting some sellers to accept the market shift. "The market hasn't settled yet,and the fourth quarter was a period with not a lot of transactions," says Tedford. "Many people took the week off between Christmas and New Years that hadn't taken that period off in years. This year, there wasn't the normal press to get year-end deals done."