U.S. markets heading toward a balanced 1999 Jacques Gordon can pinpoint to the day when the U.S. real estate market began to turn ugly. It was June 23, the second day of summer. On that day the Federal Reserve issued a warning to all member banks that it was concerned about bank lending - particularly unsecured lending - to real estate investment trusts.
"At the time this happened, we all thought it a little odd that REITs were being singled out," says Gordon, the director of Investment Research at LaSalle Advisors Capital Management in Chicago. "But as I look back on the summer, I really do think that day [June 23] events began to happen. The Federal Reserve singled out REITs as a source of concern and the REIT market reacted."
In July, REIT shares pulled back 7%. Then in August the stock market crashed, and in September the commercial mortgage-backed securities market imploded.
"In the middle of the summer, from a fundamental real estate market standpoint, we didn't see a problem," recalls Gordon. "Rents were rising, there was a lot of new construction but it was all being absorbed. It was a very interesting summer."
Although there were warning signs of weakening stock prices for REITs and cautions about too much liquidity as a host of lenders were force-feeding loans into the marketplace, 1998 began where '97 left off, with a lot of sectors in equilibrium and a portfolio of projects pushed by developers. There was so much construction activity in limited-service hotels, industrial and suburban office that some observers began to worry about overheating, but the late summer turmoil in the capital markets immediately corrected that. All of which makes offering an accurate prognostication for the industry in 1999 almost impossible.
The capital markets have been knocked so out of joint that no one really knows what it will mean going forward. REITs did stage a small stock market comeback in early autumn, but for the most part they've stopped buying, and many were selling property. Meanwhile, everyone's waiting for the next shoe to drop in CMBS and to find out who will remain in the business and who won't.
The only good news to come out of the capital markets mess is that the turmoil immediately shut down the spigot on lending to real estate, and the sectors that were overheating were building no more. "It's all working like it's supposed to," says Gordon. "Supply was getting ahead of demand. Yields were falling too fast. Now pricing has backed off a bit and speculative construction is all but shut off."
Lend Lease Real Estate Investments' Emerging Trends in Real Estate 1999 says the "bust and boom nineties" have transformed the real estate business as never before and now on the cusp of a new millennium, a breather has followed a breakneck pace. "1999 promises a market environment that recent generations have never experienced -- equilibrium."
There is, however, caution that comes with equilibrium, Emerging Trends says: "The new equilibrium - where supply and demand for space rests in a relative, if fitful, balance, signals its own host of issues and concerns for most property types." It also means that 1999 will "return real estate players to a market climate once considered normal for the asset class" - a performance level somewhere between that of equities and bonds with average returns of 10% to 15%.
The roiling of the real estate markets in 1998 may mean a significant and long-term change going forward. Hugh Kelly, chief economist of Landauer Real Estate Counselors in New York, predicts the next five years are going to be slower than the past five years. "The 1998 to 2002 period will probably mean a slower U.S. economy with a recession sometime within that period."
On a macro-economic level, Kelly points out, a number of U.S. industries underwent complete restructuring over the past 25 years. Real estate didn't begin to restructure until the early 1990s. Therefore, he says, the industry probably has another 20 years of changes ahead.
After the capital markets turmoil of 1998, the new year might just be an adventure.
Capital markets slow activity The real estate markets are closely associated with employment and job growth, observes Ken Rivkin, managing director-CMBS with Bank of America in Charlotte, N.C. "The economy will slow down, but the fundamentals of real estate are sound given that the capital market adjustment is reducing the amount of capital available for new construction."
The specter of the 1980s with too much building and no mechanism for control should not reappear, Rivkin says. "This time around, before building got out of hand, the amount of capital available for new construction - which is the biggest threat to real estate - has been cut back."
The withdrawal of capital has hit the real estate industry in two ways. When it is more difficult to borrow money, it is more expensive to borrow money which is a two-fold whammy on new development. On the other end, the price of real estate stocks have been so pummeled, the REITs and public real estate companies have less access to equity, which makes their acquisition plans more difficult to come to fruition. With less competitive fervor for existing properties, the price of real estate should settle down as well.
The dislocation of the capital markets for real estate was well in motion by the time the CMBS market began to unravel in September, Kelly says. From the first of the year through September, REITs had already fallen 20%. It is important to note, he adds, that the dislocation of capital markets had little to do with real estate and much more to do international factors such as the collapse of the Russian markets and the spreading economic contagion in places such as Asia and Latin America. Due to international financial woes, investors have turned away from high-risk financial instruments, and because CMBS features so many "B" pieces that are not rated, that whole instrument fell under intense pressure.
Emerging Trends, capturing similar sentiments, reports if there are any concerns about near-term prospects, "it centers on exogenous shocks, not real estate fundamentals." Contrary to the established notion of real estate being purely a locally driven phenomenon, the publication notes, what happens in Tokyo, Beijing or Moscow is more important to real estate than what happens on Main Street. "If world economies deteriorate further, U.S. interest rates will be lowered to soften the impact, an uncharacteristic move at this point in the real estate cycle."
Emerging Trends' synopsis of capital sources includes the following comments:
* REITs: Pricing got way ahead of the private markets from 1995-1997. These stocks will now trade at prices more aligned to a property's underlying value. Returns shouldn't fall off the chart. Expect good cash flow returns, good dividends in the 7% to 10% range, plus normal appreciation. Expect some REITs to bankroll development with bank lines of credit.
* Pension Plans: Expect pension funds to step up core investing - both in private, commingled accounts and through REIT portfolios. Pension funds have poured more than $20 billion into opportunity funds and have been well-rewarded. Wall Street firms and pension advisers still have a surplus of money to put out.
As to CMBS, Bank of America's Rivkin sums it up this way: There will be fewer players because to do this business properly you need significant capital, low cost of funds and an origination network that is cost effective. Of all the institutions that entered the business, few players can bring all the pieces together.
One other important industry real estate investor, the life insurance companies, have been net sellers of property throughout the 1990s - at a pace that picked up speed in 1998. One of the most recent deals found Allstate Corp. selling its 10 million sq. ft. investment property portfolio to Westbrook Partners for $965 million. Prudential Insurance has been disposing of its real estate portfolio for a number of years, selling off $4.5 billion since its peak ownership days in 1989. Still, the big life insurer is not withdrawing from real estate altogether. As Dave Twardock, a senior managing director, explains, "We have retained interest in some development projects that we had as part of the portfolio, we have invested in REIT stocks and we will have investments alongside our clients."
Office could have tricky year One of the properties Prudential did unload was the Embarcadero Center, a trophy complex of six Class-A office buildings in San Francisco.
Prudential along with David Rockefeller & Associates sold the Embarcadero Center to Boston Properties Inc. for $1.212 million.
Boston Properties wasn't the only REIT on the prowl as the capital markets were falling apart. Equity Office Properties Trust in Chicago announced it will buy Manhattan's 1.7 million sq. ft. Worldwide Plaza for $309 million plus the assumption of $268 million in debt.
The activity in the office sector was spurred by spectacular returns.
As Janice Stanton, director of investment research at Cushman & Wakefield in New York, points out, in 1997 and year-to-date 1998, the office sector significantly outperformed all other core property sectors including industrial, apartments and retail. In addition, the NCREIF office index for the first half of 1998 showed the office sector returned 5.6%, a healthy premium over overall NCREIF returns of 4.15%.
In a case of clearly the rich getting richer while the poor get poorer, the deals by Equity and Boston Properties only highlight what's happening in the REIT market. The big companies can still make deals, but the poorer REITs are stranded. "As a result of price erosion, the REITs are out of the marketplace. They can't get the capital to grow anymore," says Michael Silver, president of Equis Corp., a Chicago-based corporate user representative firm. "REITs are trying to conserve capital so you have to make your acquisitions selectively or not make them at all."
Equity Office and Boston Properties, both large office REITs, targeted a major U.S. city where they had little or no presence. Other REITs don't have the bulk to be so selective or opportunistic.
"The good REITs will still find ways to be successful," says Dick Schaller, executive vice president at CMD Realty Investors in Chicago.
While the major investment news in office has been with large CBD projects, development has been focused almost solely in the suburbs. According to Cushman & Wakefield, CBD construction completions through the first half of 1998 have only totaled 346,000 sq. ft. nationwide, with another 7.6 million sq. ft. under way.
In comparison, suburban construction statistics reflect significantly more activity. As of the second quarter 1998, there were 16 million sq. ft. of suburban office space built nationwide and another 60 million sq. ft. of suburban office space under construction. The latter statistic is more localized than national as 35 million sq. ft. of that total is being built in just seven markets: Dallas, Northern Virginia, Atlanta, San Francisco, Houston, Phoenix and Denver.
So much new construction in the suburban markets was making some pundits a bit nervous. "A few months ago, everyone was watching their backs," Stanton says. "People were tense about the new construction, that it was beginning of an overbuilding cycle."
That's why not everyone thought it was such a bad thing when the capital markets fell apart and liquidity was taken out of the market.
"Suddenly, overnight the capital crunch hit and brokers were running around crying, 'Oh, my deal. What is going to happen to my deal if I can't get financing?' " says Stanton. But from an economic perspective, this was the best thing that happened to the suburban market because there wouldn't be anymore capital to fund construction. "If the spigot gets turned off, you could actually extend the life of the real estate cycle. The credit crunch is really a mixed blessing in a lot of ways," Stanton adds.
CMD's Shaller would agree. "There were some markets that were getting dangerously overbuilt such as Dallas, Atlanta, Boston and Washington, D.C." Going forward, Shaller adds, there are early signs that new office construction will be slowing down as there is a "slight pull back in the amount of capital pushed into development. There is more discipline in the market now."
Still, 1999 could be a tricky year for the office market. As Cushman & Wakefield's Stanton observes, it will take a year or two to work through all the new space in the suburban market and right now absorption doesn't support the construction.
Industrial on a roll Industrial developers have been on a two-year roll, and now they're wondering if they'll end up on a rock.
"It's been a very good year," exclaims Henry D. "Greg" Gregory Jr., president and CEO of Industrial Developments International in Atlanta. As Gregory observes, industrial leasing activity has been good while development activity remains steady. During the two-year run, his company expanded into such diverse locations as Sacramento,Calif.; Fort Lauderdale, Fla.; and Juarez, Mexico.
Other companies tell of similar runs.
"For us it has been a fabulous year," croons Jerry Yahr, executive vice president of Koll Development Co. in Newport Beach, Calif. Koll, which is focused in the West and Southwest, boasts industrial projects in City of Industry, Anaheim, Carlsbad, Hayward, Morgan Hill, Union City, Rancho Cucamonga and San Diego in California as well development in Fort Worth, Dallas, Denver and Las Vegas. "1998 has been very healthy," says Yahr. "Momentum picked up in the latter part of 1997 and kept going strong. We're doing build-to-suits, back office and even a significant amount of 'spec'."
"Depending on what you define as industrial, we do have a lot going on," swings Thomas Roberts, president of Opus West in Phoenix. The company boasts industrial and back office projects from Southern California to the Bay Area around San Francisco. It is also very busy in the Phoenix market with development in the suburban areas of Tempe and Scottsdale, Ariz.
While all three industrial developers plan to be busy well into 1999, dark clouds started building on the horizon as far back as mid-year 1998. "There were indications in July that the debt financing markets were tightening up and banks were getting restrictive as to how much equity you had to have in each project and how much speculative financing they would handle," intones Yahr. What made matters worse for Koll was that most of the banks it dealt with were getting bruised in Asia and Russia at the same time potential clients were experiencing declines also due to the Asian economic crisis.
"Many of the companies that we lease to or work with are related to high technology industries, and many of these products were being shipped to Asia or created by Asian companies," says Yahr. "Now we are seeing a slowing in consumer demands, so that is going to have a trickle effect down into the industrial segment."
It is relatively easy to get industrial product built, observes Roberts, because one doesn't need a lot of equity, and there is a relatively short construction time frame. That is both bad and good. The downside, explains Roberts, is that a lot of build-to-suits were constructed and then when that market dried up, developers turned to spec building. "The supply of space caught up with the demand and absorption has slowed a little."
The good news is that industrial projects are not expensive to build. A good sized industrial plant may only cost $5 million to $7 million, and that could easily be handled by an insurance company or pension plan as opposed to a conduit loan, which suddenly disappeared from the market.
Russia, Asia, even a slowdown in the U.S. economy will all take their toll on industrial real estate, says Roberts, but this maybe a good thing. As the purse strings tighten, development will slow "and everybody has built a little bit more product than has been absorbed in the past few months."
1999 is going to be hard to predict, suggests Gregory. "Unfortunately, real estate development is capital-driven not market-driven, and the capital markets are changing rapidly. How that will impact the markets next year from a development standpoint is hard to predict right now."
To complicate matters, Gregory suspects the economy, while avoiding a full-blown recession will enter into some kind of slowdown. "Since industrial, as a real estate product, is more fundamental to corporate America, our product suffers from any kind of economic down turn."
Retail faces competition In the world of mergers and acquisitions, the mantle has passed from the hotel industry to retail. The big mall owners definitely got bigger. Simon Property Group merged with Corporate Property Investors in a $4.8 billion transaction and subsequently formed a joint venture with Macerich Co. on a $974.5 million acquisition of 12 regional malls from ERE Yarmouth. Other big deals included the $2.55 billion joint acquisition of TrizecHahn's portfolio of shopping centers by The Rouse Co. and Westfield America Inc., and General Growth Properties buying eight centers from United Kingdom-based MEPC for $871 million.
"We had a very busy year," says John Bucksbaum, executive vice president of Chicago-based General Growth Properties Inc. "We acquired outright, or bought an interest in, 17 shopping centers for approximately $2 billion." Today, the company owns and manages 122 malls and claims a valuation of $6 billion.
General Growth has remained active because as Bucksbaum notes, "Our stock held up pretty well in spite of all the volatility in the REIT sector. We had some decline in price but it has not been dramatic compared to some of the 20% drops that a number of REITs experienced."
Despite the heady performance of some of the big mall owners, technicians aren't enamored with the sector. Large REITs have concentrated mall ownership and expect to wring leasing concessions out of retailers who want to get in better properties, reports Lend Lease's Emerging Trends, but rent increases in 1999 at malls will be marginal - about 2.2%. In addition, value gains are expected to be less than robust next year - 3.2%.
CB Richard Ellis/Torto Wheaton Research, making note of the NCREIF Index which shows large, super-regional malls lagging smaller centers in returns, says the sector faces continual competition from power centers and the decline in apparel sales. Of the major retail sectors, apparel sales have been hardest hit.
It stands to reason that smaller centers anchored by grocery stores would outperform the department stores and specialty apparel stores at the malls, concludes Torto Wheaton.
Maybe this is why there has been such an interest in shopping center companies. In past years, regional mall companies grabbed all the M&A glory, but in 1998 attention turned to shopping center owners. The three big deals this year were Kimco Realty Corp.'s $835 million acquisition of The Price REIT; Excel's $1.62 billion merger with New Plan Realty Trust; and Bradley Real Estate Inc. acquisition of Mid-America Realty in a $157 million transaction.
"The transaction made sense, but I don't see any compelling reason to get bigger just to create more size," says Thomas D'Arcy, Bradley's chairman and CEO.
But it does. Large companies bring to the game greater diversity, more liquidity, investor recognition and better ability to deal with the retail chains.
In another transaction that captured a lot of attention in the industry, Taubman Centers Inc. of Bloomfield Hills, Mich., reached a definitive agreement to get back its operating-partnership units from General Motors Pension Trusts (GMPT) in exchange for 10 Taubman shopping centers. GMPT's ownership interests in Taubman totaled about 37% of Taubman Realty Group's equity base.
Taubman President and CEO Robert Taubman says the ownership restructuring will benefit his REIT. "[The restructuring will] create a strengthened, more focused development company with materially enhanced prospects for long-term growth," he says.
Meanwhile, the demand for neighborhood and community shopping center space is closely tied to the broad economic factors that drive retail sales, says Torto Wheaton, which forecasts that, over the period 1997 to 2003, annual rent growth will reach 4.8% (a real rent growth, however, of just 1.8% assuming an annual inflation rate of 3%).
As the economy expands and jobs are added, new retail space will be needed to satisfy the additional demand, reports Torto Wheaton. Over the long term the growth in retail rents will decline given new competition. However, with the strong employment growth anticipated over the next five years, retail rents should outpace the rate of inflation until 2002.
While it is true what happens to shopping center owners has to do with what happens in the local economy, the economies of nations have gotten so interrelated that what occurs overseas can easily affect a small town in the United States, says Bucksbaum: "If what happens in one part of the world affects U.S. manufacturing and industry, this affects employment and employment has a direct effect on retail sales."
Meanwhile, turmoil in the capital sector should impinge on the ability of both mall and shopping center owners to keep up the pace of mergers and acquisitions. By the end of 1998 there was already a tremendous decline in activity. "You are seeing a lot of companies back out of deals that have already been announced," says Bucksbaum. "This is something that we are going to have to deal with going into 1999."
Strong multifamily expected Generally speaking, 1998 will be a good year for apartment owners and managers, says Jonathan Kempner, president of the National Multi Housing Council in Washington, D.C. "It won't be a McGuire-Sosa year, but a solid year with dependable contributions to the bottom line."
1999 will be a little harder to predict, but multifamily markets have been fairly steady with not much in the way of drama. Even if the general capital markets continue to falter, multifamily would still have life lines attached to Fannie Mae and Freddie Mac, plus community reinvestment act obligations and plain vanilla loans from commercial banks.
M/PF Research Inc. in Dallas offers these key 1998 statistics (as of second quarter): U.S. apartment occupancy climbed to 95.5%; same facility rent growth accelerated to 4.8%; starts were up 6.8%; and 20 metro areas experienced rent growth of 5% or more in the past year. One interesting aspect of the last statistic was that the 20 cities were scattered from one end of the country to the other an included places like Seattle, San Diego, Denver, Phoenix, Dallas, Chicago, Minneapolis and Orlando, Fla.
According to M/PF, another strong performance is expected for the U.S. apartment market in 1999. However, with construction activity increasing, mid- to late 1998 probably marks the tightest conditions that will register in this cycle. Starts in 1997 - translating roughly to 1998's new supply - should total 250,000 to 275,000 units, the most new development during the 1990s.
Jack Goodman, vice president-research at NMHC, says he's a little nervous about production numbers, which indicate that the market may be pushing the upper limit of a stable level of apartment construction.
Although it would be a comfortable thing to say multihousing starts were economy-driven, there is evidence that much of it has been capital-driven. "Capital has been gushing," says Kempner. "Through the first half of the year, people were ringing all types of alarms that there was too much capital and too much building."
As with other property sectors, observers say the recent capital crunch may end up to be not a bad thing after all. "Capital has since gotten tighter," adds Kempner, "But to say it has 'dried up' would be toodramatic. To say that it has become less plentiful, particularly in some sectors, is more accurate. And while I would never want to subject any player in the apartment industry to lean times, some people would argue that a curtailed capital flow is not all that bad a thing for the industry."
Goodman adds that the demand for apartments will continue, and "as long as the industry and development community retain the discipline they acquired during the 1990s, everything will continue to be all right in the fundamental market for apartment housing. We will continue to have rent growth above inflation and we will continue to have improvements in management techniques resulting in cost savings and operating incomes."
As most economists anticipate somewhat slower job growth in 1999, many individual markets are likely to see apartment demand cool down, M/PF reports. On a regional basis:
* Metro areas in the South may be the most vulnerable to a dropoff in absorption since that region has already experienced several years of significant construction to satisfy previous pent-up demand.
* Notable building activity is just re-emerging after a lull of several years in much of the West. Some metro areas in that region still offer unmet demand for new product.
* The Northeast probably will continue to experience the strongest apartment occupancy rate during the near term. Employment expansion that leads to higher apartment demand isn't quite as strong there as in the rest of the nation, but new construction remains minimal.
Stable-to-slightly-weaker occupancy trends are anticipated for the West, Midwest and South, M/PF reports. Nevertheless, rent growth in much of the nation still should surpass overall inflation in consumer prices during 1999.
One optimistic note from NMHC is that prices of apartment properties continue to rise. The trend line of average sales price of Class A apartments has risen steadily since a low point in 1993. Earlier in 1998, CB Richard Ellis gauged the average price per square foot of Class-A apartments was up 6.8% from the same period a year earlier.
"The apartment market has been at equilibrium," says Kempner. "Volatility has not come from inside the apartment market, but from apartment finance."
Lodging growth will slow Investor nervousness about the lodging industry has pummeled the once high-flying hotel REITs. Going into the autumn, hotel REIT stocks on a year-to-date basis plummeted -40.5%, almost double the next weakest sector, office, which was off -21.3%. Companies such as Hilton and Patriot American were trading at 52-week lows. When Marriott International announced third-quarter expectations would be below estimates, the stock sank 8.4% in a heartbeat.
Facing a glut of hotel rooms in the mid-priced sector, some $2 billion worth of construction projects have reportedly been put on hold. Among the companies announcing cut-backs in development plans are Sunburst Hospitality and Prime Hospitality.
"In a two-, three-month period, the public equity market for lodging pretty much dried up and now the public debt market also dried up," observes Frank Nardozza, National Hospitality Industry director at KPMG Peat Marwick in Miami. "Worries about overbuilding coupled with the issue of poor growth prospects through acquisitions have caused some concern with lodging stock investors. At the same time, public capital markets started getting a bit concerned about new construction trends."
The bleak prospect in lodging does not pervade all sectors. The hotel market really has two branches, limited service and full service; one is overbuilt, and the other still could use new product, explains Karen Rubin, a senior vice president at HVS International in Mineola, N.Y.
"Limited service has been experiencing a lot of new supply for the past several years, and it is with this sector that we are starting to have problems with occupancy," Rubin says. "Occupancies are down a little bit industrywide, but they are down much more in limited service. It will have a bit of a weaker year in 1999 than 1998."
In comparison, full service was only now getting "geared up" and 1998 was the year a lot of people were putting their development plans together for '99 projects. "It is a little too early to tell, but it seems a lot of those will be cut back," says Rubin.
The hotel market is not as bad as REIT stocks would have one believe, claims Robert Rauch, director of business development for Interbank/Brener Hospitality in San Diego. "Occupancy this year is running at 63.7%, which is down less than a point from 64.% the previous year, and average room rates are up 5%, still above the consumer price index."
While Rauch predicts room rate growth will slow to 4% in 1999, he says the industry will see larger profits in 1999 than in 1998.
The industry was definitely on a roll in 1998, adds Nardozza. "The overall rent power in hotels increased with occupancies moving up in most segments." General statistics unfortunately hide a number of sins. Nardozza concedes considerable unevenness among markets.
In the mid-1990s, rising occupancy in such markets as Phoenix, Dallas, Atlanta and Philadelphia prompted a building boom of limited-service product. Now all these cities are glutted with too many hotels in the sector. In Miami, something a little different is going on as six major, full-service hotels are being developed. Meanwhile in places such as New York, it's impossible to get a room mid-week.
"The limited-service sector is not awful, but will be a little soft in 1999 compared to 1998," concludes Rubin. "There will be good to excellent progress in full service. It may not come in occupancy, but it will come in rate."
Real estate markets are sound "We are not headed for a major economic crush in 1999," says Rubin. Others would agree. However, if they are wrong and there is a recession in '99 or the year after, most real estate professionals maintain it will not be the same crushing blow to real estate as happened in the 1980s.
When the economy faltered a decade ago, the real estate market was considerably over-developed. Although development did pick up through the course of the 1990s, even hot sectors such as suburban office or limited-service hotels did not get too far out of whack. Moreover, an excess of liquidity in 1997 and early 1998 might have contributed to a situation of supply being extremely out of balance with demand, but the collapse of the capital markets late in 1998 very quickly halted that possibility.
The real estate markets are sound, says Bank of America's Rivkin. "The capital market adjustment is reducing the amount of capital for new construction which means the biggest threat to real estate fundamentals has been cut back."