Although the industry staggered after the one-two punch of the dot-com crash and the Sept. 11 terrorist attacks, commercial real estate isn't down for the count, according to investors. A survey of 150 professionals conducted jointly by New York-based Lend Lease Real Estate Investments and PricewaterhouseCoopers reveals 72% of respondents believe real estate, including private equity and REITs, will outperform U.S. stocks in the year ahead. In addition, 92% say real estate will outperform bonds.

According to Peter Korpacz, director of the global strategic real estate research group of PricewaterhouseCoopers, strong real estate fundamentals combined with a lack of overbuilding have set the stage for the industry to overcome economic weakness. “We were almost at equilibrium at the peak, so we were in a good position going into a downturn, unlike the 1990s,” Korpacz said. “We can afford to lose.”

In “Emerging Trends in Real Estate 2002,” Lend Lease and PricewaterhouseCoopers asked more than 150 industry experts — including investors, developers, lenders, brokers, researchers, consultants and planners — what to expect in the year ahead.

Most surveys were taken during the summer of 2001, but follow-up questions after the Sept. 11 attacks on New York and Washington, D.C., show that the real estate industry remains a bystander rather than a driver of the economic downturn, with events only amplifying previous industry weak spots. In its 23rd year, “Emerging Trends” predicts a difficult, but manageable, year ahead.

Investments in the black

The authors of the report conclude that a recession followed by modest economic growth will lower returns for real estate investors. Jonathan Miller, survey editor and a principal at Lend Lease, cites a two-stage deterioration in demand for space that began with the tech wreck and was exacerbated by the Sept. 11 terrorist attacks.

“People became increasingly gloomy, and this was only punctuated by the Sept. 11 events,” Miller said. He added that, at the very least, the attacks created the perception of a recession, dashing America's sense of security. “The economy will determine how deep the real estate decline will be,” Miller said. “But we view it as more of a dip than a bust.”

The consensus among survey respondents is that real estate is a comparatively safe haven. Income-oriented investments such as apartments, community shopping centers and industrial properties rank the highest, while office space and R&D space lose ground in the wake of the tech implosion. “This is the best year to invest because of the more modest cycle,” Miller said. “The market bottom will occur in 2002 with a modest upward trend over 2003 to 2005.”

“Emerging Trends” highlights three particular factors that may influence an investment's health over the next year:

  • The economy. “Almost unanimously, respondents view the economic and worldwide political tides as determining the health of real estate markets in 2002,” the report states.

  • Pricing and cap rates. Experts see pricing in most sectors as stagnating or slightly declining, and cap rates are expected to drop as a recovery takes hold. (Cap rates run inversely to purchase prices. The lower the cap rate, the higher the purchase price.)

  • Value changes. Limited-service and full-service hotels, power centers, suburban office space and regional malls are expected to encounter a dip in value.



Keep an eye on these markets

The 24-hour markets again topped the report's list of cities that show potential for better risk-adjusted returns. The “consensus six” is made up of megamarkets New York, Washington, D.C., Boston, Chicago and San Francisco, as well as the Southern California suburban agglomeration of San Diego to north of Los Angeles. In a bittersweet outcome, New York was named the best investment market for 2002, as former No. 1 San Francisco dropped due to the ripple effect of the tech wreck.

“People have really gravitated toward 24-hour cities because of their convenience and high profile,” Miller said. Experts say the 24-hour dynamics of the “consensus six” cities are a recurring theme for success because they prompt a quick recovery from the 2001 deluge of sublease space. In addition, “properties in better-planned, growth-constrained markets hold value better in down markets and appreciate more in up cycles,” the report asserts.

However, “Emerging Trends” points out that glitter doesn't mean gold. The 24-hour cities have several issues threatening their high standings:

  • The souring economy. A weakened economy will test local governments as the upward economic spiral of the 1990s reverses its course.

  • Federal government indifference. President George W. Bush's core constituency resides in the suburbs and rural areas, so more federal monies will be spent in those areas, the report contends. The one exception is New York, as the federal government helps the city clean up in the aftermath of the World Trade Center attacks.

  • Public schools debacle. “Today's Generations X and Y now gravitate to the pulse and allure of big-city lifestyles, but tomorrow they won't put their children's education at risk in city schools beset by teacher shortages … and safety issues,” the report predicts.

  • Housing shortages. Affordable housing for middle-income residents, the urban industry backbone, is essential.

  • The fear factor. The Sept. 11 attacks have stirred an uneasy atmosphere in urban environments, and now the suburbs look a lot safer. “A lot hasn't played out yet in New York,” Korpacz said. Lease expirations are the wild card that will determine New York's fate, and it will be six months or more before occupancy trends can be identified. “Millions of square feet come up for renewal each month,” Korpacz said. “There is much uncertainty whether companies will renew that space.”



Beyond the 24-hour giants, investors are hesitant to pursue other markets. According to Korpacz, investors are refocusing on core geography after diversifying in recent years. “They are sticking with major cities in times of uncertainty because they are markets that they know and where they already have properties,” he said. The “next best” tier (including Seattle, Miami, Denver, Philadelphia and Minneapolis) are struggling to overcome tech-wreck and growth issues.

And what about the future of hot markets? They're going through a transition as a decade of uncontrolled sprawl and skyrocketing population growth catches up with them. This tier includes Houston, Phoenix, Atlanta and Dallas. “Atlanta and these other markets are not as multi-dimensional places as the 24-hour cities,” Miller said. “They're strangled in traffic.”

“Emerging Trends” also warns savvy investors to be aware of utility issues that may constrain future growth. Although survey authors term power shortages a “red herring” rather than a real issue in most states, several major markets are seriously vulnerable to supply issues.

In California, New York and Florida particularly, energy capacity severely lags demand. And water shortages, which circle back to power supplies since most power plants require water to operate generators, also raise a red flag. Desert meccas such as Phoenix and Las Vegas face water shortages as a result of soaring population growth. Georgia and neighboring states are battling over the rights to the Chattahoochee watershed, while Florida is struggling with saltwater contamination of its low water table.

Taking a risk

With low interest rates, public market discipline and controlled supply, “Emerging Trends” paints an overall optimistic picture for commercial real estate investment heading into the downturn. “People are waiting on the sidelines until we're at the bottom,” Miller said. “The deeper the downturn, the better for opportunistic investors.”

Investment tips for 2002

  1. Be ready to move quickly and keep an eye out for bargains.

  2. Buy multifamily — but only in select markets. Prune older commodity multifamily assets.

  3. Buy office in the battered high-tech markets, as well as in downtown 24-hour markets.

  4. Leverage core assets.

  5. Watch for REIT correction, and buy into office, apartment and industrial stocks with a larger market cap.

  6. Look for commodity properties in top infill locations and megalopolis infill areas.

  7. Hold industrial, R&D and fortress mall space as the markets recoup.

  8. Hang on to full-service hotels, but steer clear of limited-service hotels, (“B” and “C”) power centers.

  9. Be careful of grocery-anchored retail.

  10. Avoid second-tier and tertiary markets.
    — Source: Lend Lease “Emerging Trends 2002” survey