Retail real estate entered 1998 on a roll. Capital was plentiful and cheap, property values and investment returns were high, and rising corporate growth was being rewarded by the stock market. Indeed, it was smooth sailing for the real estate industry.

But the placid waters of January belied the rough seas that were to surprise the captains of industry in the second half of the year. The world economy experienced trouble in Asia and then Russia. And due to the growth of securitization, the business world truly had become a smaller place.

As the demand for overseas goods began to decline, so did profit projections for many American corporations. Real estate developers - who increasingly had pursued foreign retail projects in search of greater returns in less competitive markets - soon felt the effects of faltering economies half a world away.

The signs of a slowing economy were quickly noted by investors, already suspicious of this decade's prolonged period of economic expansion. The increased influence of international economies upon each other was about to become apparent.

As the year progressed, investors became skittish over the numbers they were seeing, and a flight to quality ensued. Suddenly, only the cream of real estate transactions could get financing as a near-term capital crunch was created. The lack of liquidity and the absence of REITs from the marketplace, due to dwindling stock prices, lowered real estate values as much as 15%, reports Dallas-based AMRESCO Research.

"Today, what happens in Tokyo, Beijing or Moscow is more important to real estate than what happens on Main Street," warns one researcher in "Emerging Trends in Real Estate 1999," published in October 1998 by Lend Lease Real Estate Investments and PricewaterhouseCoopers, both based in New York. "Once-isolated regional financial woes can now send instant shockwaves through world stock markets and banking systems."

Trouble masked by strong numbers The problems certainly were not related to the domestic markets, whose fundamentals remained strong, particularly in the retail sector.

At year's end, AMRESCO Research reported a 6.5% vacancy rate for investment-grade centers, the lowest in 14 years. In addition, rent increases were ahead of inflation, mortgage delinquency was at a historic low, and returns on retail investment had risen to double-digit levels for the first time in more than a decade.

The basic numbers are not expected to undergo much change. "Over the near term, the underlying supply-and-demand property fundamentals are expected to remain in relative balance," states a late-1998 AMRESCO Research report on the U.S. economy.

"Unlike the early 1990s, the problems that occurred in 1998 were due to secular events. In other words, they were totally unrelated to the assets," says Damian Zamias, president and CEO of Johnstown, Pa.-based Zamias Services Inc.

But regardless of the cause, the problems were serious. The repricing of REIT stocks and CMBS has, and will, run some small trusts and conduits out of existence. Certainly, the major occurrences of 1998 will not soon be forgotten by financing and real estate executives.

After brisk M&A, now what? The devaluation of REIT stocks began in the second quarter and didn't bottom out until October. The down period ended a five-year growth cycle for the trusts, during which time they had evolved into major players in real estate development. And they were even a bigger part of the retail sector.

"In January 1998, Wall Street analysts thought it was almost a natural law that REIT stocks would trade above the value of their properties," says Hugh Kelly, chief economist with New York-based Landauer Real Estate Counselors. "This strength gave REITs the capital to acquire properties, and they were rewarded by increased efficiency and a rising stock market multiple."

This was a major factor in the brisk merger and acquisition activity during the first half of the year. Simon Property Group acquired Corporate Property Investors; The Rouse Co. and Westfield acquired TrizecHahn; Trammel Crow acquired Faison & Associates; and numerous smaller mergers were transacted as well.

Many large portfolios were also changing hands, with CBL & Associates, General Growth, Macerich and The Mills Corp. active buyers of large malls, and Pan Pacific Retail, JBN Realty and Regency Realty leading the way in strip center acquisitions.

While consolidation was being rewarded, firms large and small were looking for other ways they could cooperate and still maintain independence. Joint ventures and business alliances have proven a beneficial compromise to mergers.

Last year, The Taubman Co. and The Mills Corp. agreed to a joint venture to develop regional malls around the country. The 10-year pact was forged from an existing working relationship between the firms, where each has benefited from combining the two firms' various development capabilities.

In another type of alliance, Burnham Pacific Properties has become the exclusive venture partner for CALPers (California Public Employees Retirement System). Burnham Pacific will provide development expertise and CALPers will supply most of the capital for projects.

These alternative arrangements should continue as REITs seek ways to increase profits. As "Emerging Trends" states: "Opportunity funds and REITs anxious to maintain growth rates with off-balance sheet borrowing are teaming up on new projects. The opportunity players front the costs, and the REITs take them out when the properties are leased."

REITs return to earth After a successful growth period, REITs should have expected a fall. But during their long run at the top, so many similar predictions had proven wrong that few paid attention any longer.

But the warning signs were there. "REITs entered the year on peak valuation [and] earnings were decelerating," says Stuart Axelrod, research analyst with New York-based Lehman Brothers. "Whenever that happens, you are going to see a correction."

Other observers attest to the industry's blind eye. "There were red flags up, but people chose to ignore them," says Therese Byrne, president of Byrne Associates, a New York-based retail consulting firm and editor of "Retail Maxim," an industry newsletter.

Every category of REIT experienced dropping stock prices. However, retail REITs did better than those in other categories. "Everyone bled - it's just that some bled less than others," explains Mark Berry, who tracks REITs in his position as vice president of New York-based Duff & Phelps Credit Rating Co.

Anyone surprised by the decline in REIT stocks may have confused their dominant position in the retail world with their overall place in the stock market pecking order.

What was apparently not understood by some real estate executives was that REITs are small-cap stocks. Kelly underscores this fact by comparing REITs with other stock indexes. There are about 200 publicly traded REITs with a total capitalization of approximately $160 billion. By comparison, inthe stock market's Transportation Index, for example, there are only 15 companies - but with a capitalization of $175 million.

"In the stock market, large-cap firms are usually more stable," Kelly says. "So when the turmoil in the stock market began, investors concentrated their buying on large-cap stocks, and small-cap stocks did not have a good year."

REIT stocks lost value as a result. But while REITs lost a total of 23.8% of their value through October, according to Lehman Brothers' REIT Index, mall REITs lost only 8.3% of their value and strip center REITs lost only 7.6%.

One reason retail REITs fared better in 1998 was that they were unpopular with investors during the previous few years. "The REIT stocks that increased in 1996-97 were the hotel and office variety," explains Axelrod. "Retail REITs simply did not have as far to fall."

In effect, the reduced stock value of REITs took them out of the acquisition market, as evidenced by REIT investment statistics compiled by NAREIT. Total investment by REITs dropped each quarter during the year: $20.1 billion in the first quarter; $13.3 billion in the second quarter; $8.1 billion in the third quarter; and $3.4 billion in the fourth quarter.

Retail REITs, on the other hand, were less affected by the stock turmoil and more than doubled their amount of investment from the first to second quarter before slowing down. "Retail REITs continued to buy until it was impossible to make the numbers work," explains Berry.

Although REIT stocks rebounded as much as 10% late in the year, the trusts are not expected to jump back in the acquisition market anytime soon. "Right now, they are trying to digest all of the acquisitions made the past few years," says Joe Edens, chairman of Columbia, S.C.-based Edens & Avant, a private firm that was among the most active buyers of retail in 1998.

Edens notes that, with fewer REITs to compete with, his firm had greater choice of acquisition opportunities and probably paid less for what they bought. "The absence of REITs placed some downward pressure on prices," he says.

Easy come, easy go Kelly says his first concerns about the CMBS market came in April of last year at a trade association meeting. An executive for a large conduit lender reported that his company had a target goal of securitizing $1 billion of debt per month during 1998.

When the floor was opened for questions, a lender asked how the conduit lender could adequately underwrite that volume of loans each month. In response, the executive shrugged his shoulders and said, "Clearly our standards have dropped, just as everyone's standards have dropped."

Hearing these words from a top conduit executive had to be unsettling to many in the audience, considering the exponential growth that was taking place in the CMBS market.

But again, the strength of real estate fundamentals, the steady decline in real estate loan delinquency rates and an increase in returns on retail properties had investor interest rising and seemingly everyone anxious to get in on the CMBS money machine.

"The battle was for market share," explains Zamais, "and to grow faster than the competition, conduits had to take additional risks." This competition made for thin CMBS spreads that were getting thinner all the time as new conduits were formed.

Capital was flowing for all manner of real estate projects. In January, Lehman Brothers provided $13.1 million to refinance Trexlertown Plaza, a 212,000 sq. ft. shopping center in Trexlertown, Pa. In February, it provided a $13.5 million first-mortgage loan for The Market at Wolfcreek in Memphis, Tenn. In March, New York-based Donaldson, Lufkin & Jenrette provided $18.2 million to Charles E. Robbins, Springfield, Ill., for the first two phases of Southwest Plaza in the same city.

And as late as July, New York-based Nomura Capital - which has since been renamed The Capital Co. of America LLC - provided a $150 million loan to a Burnham Pacific Properties affiliate for the purchase of 20 retail properties. Research by Houston-based Holliday Fenoglio Fowler LP indicated that, through the third quarter of 1998, conduits had issued almost $40 million, or 70% of the year-to-date CMBS total, with 27.3% of the total invested in retail.

But investors had begun to question the thin spreads. "By the second quarter," says Byrne, "word got out that everyone was overpaying, and the spreads quickly began to widen."

Recalls Zamias, "Soon there was a situation where the price quotes for CMBS were 150 basis points over Treasury bills in a market that was not willing to buy, unless the price was 300 to 400 basis points over."

In September, Greenwich, Conn.-based Long Term Capital Management, a large hedge fund with a major position in the CMBS market, defaulted on the heels of the Russian debt default. Suddenly, 50% of purchasers for low-rated and non-rated debt went out of the market all at once.

Many conduit deals stalled. CMBS issuance estimates for 1998 were revised downward to $70 billion, from the $90 billion estimate made in the second quarter. "This suggests only about half of the $32 billion (30 deals) of forward supply will price by year's end," states Holliday Fenoglio Fowler's October CMBS report.

"The current problem is that there is far too much CMBS paper to be unloaded and far too few buyers. .... There will need to be a steep discount price set to attract capital back to the asset class," reports Landauer's 1999 Real Estate Market Forecast.

"Those most severely impacted have been conduit lenders, mortgage REITs, holders of CMBS "B" pieces, and borrowers trying to finance property deals," states AMRESCO's October 1998 report on the CMBS market.

The turmoil left a void in the real estate capital supply that was quickly filled by pension funds and life companies, reports Landauer. This led to more alliances between capital sources and developers.

1998's legacy The real estate turmoil, though intense, lasted only a few months. October seems to be the month the bottom was reached. By the end of the year, REIT stocks had recovered some lost ground. The credit crunch eased a bit and the CMBS market was still stalled, awaiting a significant repricing. CMBS will remain a major capital source, but absent some of the conduit lenders most heavily involved in 1998, such as The Capital Co. of America.

Despite the severity of the problems, many in the industry regard the "correction of 1998" as a positive for real estate.

"I think what happened was very healthy," says Edens. "The discipline it forced on the industry was a wake-up call that will benefit every segment of the market."

For Kelly, 1998 was a year of discovery. "We are all still learning about how capital markets affect real estate markets," he says. "But it will be a few more business cycles before we have a firm handle on CMBS."

Another benefit cited is the expansion of the lending base. "There are more choices than ever before for sourcing funds," states Emerging Trends. "Conduits have established themselves as primary lenders alongside commercial banks and life insurers."

For retail specifically, a better-than-expected sales year - topped off by a strong Christmas season - should maintain the investor interest so prevalent at the beginning of the year.

In general, most retail industry watchers will remember 1998 as the year REITs and the CMBS market were brought back to reality.

"It was a learning experience," concludes Kelly, compliments of the school of hard knocks.

Mergers File - 1998 The following were among the major corporate mergers of 1998.

Los Angeles-based CB Commercial Real Estate Services Group Inc. merged with London-based REI Ltd., which operates outside the United Kingdom as Richard Ellis, to form CB Richard Ellis. The global real estate services firm now has more than 8,000 employees and more than 200 offices in 29 countries.The firm will be based in Los Angeles.

Indianapolis-based Simon Property Group Inc. acquired Corporate Property Investors (CPI), New York, and its paired-shared affiliate, Corporate Realty Consultants Inc. As a result of the deal, the Simon portfolio grew to 241 retail properties in 35 states comprising a total GLA of 165 million sq. ft. The transaction valued CPI at approximately $5.78 billion, including the assumption of debt.

Dallas-based Trammell Crow Co. acquired Faison & Associates Inc. - a Charlotte, N.C.-based commercial real estate firm specializing in the development, leasing and management of office, industrial and retail projects - for $39.1 million. The acquisition increased Trammell Crow's leasing and property management portfolio by 22%.

Jacksonville, Fla.-based Regency Realty Corp. acquired St. Louis-based Midland Group and 21 of its shopping centers for approximately $253 million. Midland will operate under the Regency Realty Corp. name. The acquisition brings Regency's retail portfolio to 13.2 million sq. ft.

1998 Transactions These are some of the major retail real estate transactions of 1998.

The Rouse Co., Columbia, Md., and Westfield America Inc., Los Angeles, acquired the shopping center portfolio of Toronto-based TrizecHahn Corp. The purchase did not include the staff or projects of TrizecHahn Development Corp. The portfolio's 20 shopping centers comprise 19 million sq. ft. of GLA located in eight states. Westfield America acquired the 13 TrizecHahn properties in California and Washington for up to $1.44 billion. The Rouse Co. acquired the seven remaining properties for up to $1.11 billion.

Indianapolis-based Simon Property Group Inc. and The Macerich Co., Santa Monica, Calif., formed a 50/50 joint venture to acquire 12 regional malls (a combined total of 10.7 million sq. ft. of retail GLA) from New York-based ERE Yarmouth for $974.5 million.

New York-based Nomura Capital (Capital Co. of America) provided a $150 million loan to San Diego-based BPP Golden State Acquisitions LLC, an affiliate of Burnham Pacific Properties, for acquisition of a portfolio of 20 California neighborhood centers. This 10-year permanent mortgage loan is amortized over 30 years and represents almost half of the portfolio's purchase price.

Chicago-based General Growth Properties Inc. acquired a portfolio of eight malls from London-based MEPC plc, the parent company of Dallas-based MEPC American Properties, for $871 million. The portfolio, which was 87% occupied at the time of the sale, contains 7.7 million sq. ft. and produces average annual sales of $328 per square foot.

Columbus, Ohio-based Glimcher Properties acquired University Mall in Tampa, Fla., for $121 million. The 1.3 million sq. ft. enclosed, superregional center was sold by Chicago-based Heitman Capital Management on behalf of its pension clients.

The Los Angeles office of Baltimore-based RTKL Associates Inc. received the design contract for Waikiki Royal Walk, a $142 million, 280,000 sq. ft., five-level retail center being developed in Honolulu by locally based Myers Corp. The design of the project includes four terraced levels to provide maximum visibility to upper-level shops and a courtyard and water feature. The development was scheduled to begin construction late in 1998. Prime Retail, Baltimore, purchased two shopping centers from Benderson Development Co., Buffalo, N.Y., for $101 million: Niagara International Factory Outlets (534,000 sq. ft.) in Niagara Falls, N.Y., and Shasta Factory Stores (165,000 sq. ft.), in Shasta, Calif.

New York-based Lehman Brothers provided $13.5 million in first mortgage financing to Trezevant Realty Corp., Memphis, Tenn., for the first phase of The Market at Wolfcreek, a 575,000 sq. ft. center, in Memphis.

Donaldson, Lufkin Jenrette, New York, provided $18.2 million to Charles E. Robbins, Springfield, Ill., for phases I and II of Southwest Plaza, a 225,889 sq. ft. center in Springfield.

Los Angeles-based Altoon + Porter Architects is designing a 1 million sq. ft. shopping center at Kowloon Station in Hong Kong. Part of a 33-acre, multibillion dollar mixed-use development of the Hong Kong-based Mass Transport Railway Corp., the project will include 12 million sq. ft. of office, hotel and residential units. The developer expects shopping traffic of 190,000 people per day.