Commercial real estate has long been a staple of the life insurance company diet, and so far in 1999 that has definitely proven to be the case. In many cases, the life companies have stepped in to fill the financing void left in the wake of last fall's dramatic credit crunch.

Which is why NATIONAL REAL ESTATE INVESTOR partnered with Transwestern Commercial Services to hold a roundtable of leading life insurance company executives in Dallas. The downtown Fairmont Hotel provided a nice backdrop to hear what these leading executives have on their minds.

Ben Johnson: How do you view the overall fundamentals of today's commercial real estate industry? Are we in equilibrium or about to fall off the proverbial cliff?

Brian Murphy: Generally we think the markets are in equilibrium. With rising occupancies, reducing vacancies and stable capital markets, we feel pretty good about it. If you look at our mortgage loan portfolio, we've had historical lows in terms of defaults and foreclosures. Our watch list has been virtually eliminated over the past few years.

But we're also a little cautious. The underwriting standards for our mortgage loan operation are as conservative as they have been in the past. We've thought about the office markets as being a lot more volatile than other sectors within the real estate industry, and as a result, in terms of our lending activities, we're moving towards some other property types that are a little less volatile, be it industrial or multifamily residential.

Mike Cusick: We're a little bit beyond equilibrium. On the equity side, we're pulling back a little bit. We've emphasized apartments and warehouses over the past several years and we want to get the product leased up that we do have now before starting a lot of new product. We think there are certain areas of the country that present good opportunities going forward. There are certain other areas that we are definitely pulling back from.

On the debt side, we are still being a little cautious. There is certainly nowhere near the concern that we would have had in the late-'80s or early-'90s. We do see good opportunities and we anticipate doing $2 billion to $2.5 billion of debt business and probably half a billion [dollars] of equity business this year. But a lot more cautious than a few years ago. The structure of the deals has changed. When we see the structure changing to the degree that it's changing now, then we start to pull back a little bit.

John Garrison: My perspective is colored a bit by what's happening at Hancock. The sales program that we're going through, which has basically liquidated the equity portfolio, is probably more driven by going from a mutual to a public company, and that is scheduled to take place in mid-2000. The thinking was that analysts looking at the company would penalize too much for equity real estate, beyond what the fundamentals are.

My own personal view is it's a mixed blessing. To the extent that it's a macro question, we're talking about the economy. If the economy remains healthy and inflation remains low, I'm not sure that is good news for equity real estate. Historically, real assets do well in an inflationary environment and paper assets do well in a non-inflationary environment. Equity real estate is an expensive asset to own, it costs money to keep it up and going and I don't think we're going to see the kinds of returns ... We've just come out of the recovery from the down cycle of the early-'90s and I don't know that we'll see that going forward.

Greg Hauser: We're thinking about markets and what's driving our thinking today can probably be broken into two areas, one being what our beliefs are about what is going on in the space markets and then secondly what is going on in the capital markets.

In the space markets, we look at things as we look at the outlook for revenues and earnings. As we look at the outlook for some of the fundamental drivers for demand and supply, the basic theme coming through to us, over the short term and intermediate and probably even long term, is a fairly stable to modestly improving environment. We see revenues and earnings gradually increasing for almost all real estate assets domestically. A lot of that is driven by what we believe is going to happen with population, employment and income growth, and the discipline that exists on the supply side of the equation.

When you switch to the capital markets, that is an area where we see probably a significantly more volatile environment. One of the key reasons is a lot more global access to investments of all types. The public market is clearly growing as a much more significant force in our business with commercial mortgage-backed securities and the equity REITs. Moving our investments into a more tradable format is going to inject a lot more volatility into capital-market pricing for our assets as we are buying and selling properties and pricing on mortgage loans.

Dave Johnson: If you look at the economy, it seems the real estate industry should be easy, but if you start breaking the business down it doesn't appear to be that easy. At CIGNA, we've always been a major player in the regional mall business and if you look at that business today there is nothing easy about it. Our stats for major malls continue to get better, so you have the strong getting stronger and the weak getting weaker. If you switch to the office side and look at the employment gains, the numbers are staggering but we're developing office buildings around the country and it's awfully difficult to lease office space. The statistics shouldn't say that's so, but we're struggling on the office side. We're wondering where all of these workers are working, so we need to find them.

Then for apartments, the demographics are against it, but all of our apartment investments are fabulous. Yet there aren't many young people and you would think that part of the market would be going south but it's going in exactly the opposite direction. So the formula has kind of changed.

Steve Pumper: I would like to hear about your commitment to the equity side of the business and how you will participate on that side in the future.

Robert Merck: For Met Life, we have basically sold down the portfolio. We have been through a pretty major sales process in '94, '95, '96 and '97 and we have a stable portfolio and we're going to maintain that portfolio. We feel good about equity real estate and we're actually in the market right now looking at selective acquisitions to help diversify the portfolio. We just acquired a high-end new apartment complex in Houston from Trammell Crow.

We've also looked at selective development opportunities. We've just finished a building in Atlanta in the North Fulton (County) submarket that is now 100% leased. We've got another one under construction there and we're looking at select development opportunities for apartments.

Cusick: Our equity portfolio has actually grown quite a bit over the past few years. We probably averaged $800 million to $1 billion of equity activity over the last three or four years, principally in apartments and warehouse product, although we have done office building developments in Atlanta, here in Dallas in Las Colinas, Washington, D.C., and in the Chicago area. Our main focus has been in apartments, which we feel is a lot less risky than office product.

We are committed to the equity side of the business going forward because we think it creates great opportunities for return and enhancing the policyholders' dividends.

Bruce Gadd: Our subsidiary, Cornerstone Real Estate Advisors, has been concentrating largely on hotel and office product and acquisitions around the country and feels very good about it. We're starting some outside funds which are attracting third-party capital and acting more as investment advisers investing our own money along with others.

Hauser: Most all of the money we manage today is for Principal Life Insurance Co. We have about a dozen other institutional clients. Focusing on the general account of the life insurance company, to contrast some of Mike and John's comments, Principal has converted from a legal entity to a mutual insurance holding company structure. The idea is to position yourself to sell stock, and either way, equity real estate does not fit very well in that kind of an envelope.

We've been trying to figure out are there ways to leverage off the real estate expertise andutilize that expertise for the life insurance company as a client. We're continuing to search for ways to do that, but however it's done, we're going to find that, for our general accounts at life insurance companies, it is in all likelihood going to significantly shrink their exposure to equity real estate.

We have recently started up some new programs for the life insurance company. One of them involves a sort of merchant-build, merchant-development program.

Dave Johnson: On the equity side, you have to feel pretty comfortable these days. You still can buy properties in the 8% to 9% cap rate, and when you can leverage in the 7% range, obviously that gives you a little hit to your returns. It's very unusual that cap rates are that much above mortgage rates, so I think most of us are playing off of that leverage factor at this point in time.

The concern on equity real estate is that the stock market is seeing returns of 30%. People are now trying to duplicate those type returns in real estate. We had the chance to do that with the opportunistic funds as values came back quickly; we could provide those type of returns. Unfortunately, investors are now used to that type of return and I think the biggest challenge on the equity side is getting expectations back in line with reality. It's not the type of asset class that can easily generate those type of returns.

Charles Milner: Travelers' equity strategy going forward is going to be primarily based in co-investing in funds. We've already sponsored two funds and our third fund, which will have an international property orientation to it, is on the drawing board.

We have done select single-asset equity investment over the last couple of years and I think it has been very successful, but in terms of resource allocation, No. 1, within an organization that has a pretty small number of people to leverage off of, we don't think that's the best use. The other issue that has arisen is that IRRs (internal rates of return) can be attractive, but our investors, who are primarily insurance company portfolios, are looking for more current returns. We think we can do that better using the fund approach and using the money-raising capability of our sister company, Salomon Smith Barney.

Pumper: How are you going to handle or structure your ownership on the equity side of the equation?

Murphy: There are a couple of parts and it all knits nicely together. Prudential is going to de-mutualize and we feel that holding core real estate assets is not a good fit with our portfolio and Prudential has to get better returns for their investments so they can pay dividends to their policyholders and sell more insurance. So it's a complicated calculus as to where you want to invest your money to get the highest risk-adjusted return.

One of the ways we've tried to maximize revenue for the parent is to expand our investment advisory business. As part of our sales program of core real estate, we started a new program which we call Strategic Value Investors. As part of that, we created opportunities not only for Prudential but also for Prudential's clients to invest in securities of companies that were buying some of our assets. We created the first fund called Strategic Value Investors I and then a subsequent fund SVI-II and both of those funds are fully subscribed. The total investment in them is about $650 million.

We've also created a fund that will invest in private real estate companies, with the hope that we ultimately could grow those businesses and take them public. And we've also created a number of international funds, with European property partners and Asian property partners, that will allow us to bring in institutional money to co-invest with us and to earn advisory fees and placement fees.

Dave Johnson: I found it interesting that on a couple of major regional mall packages that sold last year, the REITs actually bid at cap rates that the private market wouldn't bet at, and then they went to the private market to leverage up those acquisitions and had to pay a higher preferred return in the private market than they did buying the asset themselves. So they sort of leveraged themselves backwards.

Garrison: Just a global comment about REIT investing versus direct equity investing, which is a simple concept to me. The whole idea of a REIT being able to combine the advantages of stock with equity investing ... if I own real estate I want to control the asset, to decide where I'm spending the money and how I'm spending it, and to me that's the big advantage of equity real estate investment versus direct stock investment.

Pumper: Now who wants to address the debt side of the business?

Debra Kloper: I think the conduits were out of the business last year, but they've started to come back in. They are getting more aggressive on their spreads. They adjusted their underwriting, which is a good thing and that's why we feel now is the opportunity for us to also get into the market.

The other interesting thing that has happened is that because of the market adjustment and the rating agencies getting nervous that they were to blame for allowing a lot of these conduits to continually lend these levels at high leverage on properties, they have now put more credence into insurance companies' underwriting standards. Which is a really good thing for us since I think we've always been better underwriters, more conservative and more realistic.

As far as the REITs go in relation to the debt, we are looking at REITs as our borrowers now, which we never had that opportunity to do because they can't go to the capital markets and get money cheaper than they could if they came to us as a lender. So that is a positive because they are good borrowers and they don't leverage as high as some of the other borrowers that we've seen.

Gadd: I hear a lot about conduits becoming active again in our markets, but we don't run into them as much as you might think we do. Our competitors are still sitting around this table here and I think as long as we are in the product types and the size of loans we are chasing, that will continue to be our competition. And we are also seeing a lot of REIT business like Debbie said. They are unable to borrow anywhere else and they are now leveraging up some free and clear assets and we are seeing lots of good portfolio opportunities in low-leverage transactions.