Following the longest expansion in U.S. history, the property markets are experiencing the brunt of the first economic contraction in a decade, according to AEW Capital Management L.P. "Vacancy rates are rising, rental rates are falling and valuations are under pressure," the report says.

The research report by the Boston-based real estate advisory firm details the United States’ current economic conditions and their effect on the overall real estate market cycle. The report also examines the outlook for investment opportunities in real estate capital markets.

According to the report, timing will determine the recovery of the real estate markets, but the short-term economic picture reveals little or no job growth, rising unemployment and constrained consumer spending. "The performance of commercial real estate, a lagging sector throughout the cycle, will deteriorate further before any improvement occurs," the report says. "While timing will vary by property and geographic market, we expect aggregate commercial real estate markets to bottom-out by the beginning of 2003."

In the long-term, the report found prospects for real estate favorable, with the "echo boomers" — the children of the baby boomers — moving into the workplace over the next 15 years. According to the report, the demand for yield-oriented investments such as real estate stands to increase considerably as the baby boom itself begins to move into retirement during the next decade.

"We’re telling investors to look ahead — be cautious, but don’t ignore the opportunities that continue to exist," says Douglas Poutasse, chief investment strategist at AEW.

Cautious and conservative capital
According to the report, real estate capital markets in 2002 will be similar to last year’s conditions. "Today’s markets are characterized by an abundance of cautious equity and low-cost debt capital guided by conservative underwriting parameters," he says.

Entrepreneurial investors will continue to compete in markets once dominated by institutions. "Non-institutional investors were among the most active buyers in 2001, particularly of properties in secondary markets. This trend should continue into 2002 as long as interest rates remain low and capital remains plentiful," says the report.

Transactions slowed in the second half of 2001 due to a growing bid-ask spread, which the report defines as the difference between what buyers are willing to pay for a property and what sellers expect to receive. As the economy heads toward recovery, AEW expects the transaction volume to increase. "Today’s property values are much more realistic than they were when we entered the last recession in 1990," says Poutasse. "We do not anticipate anywhere near the kind of pricing correction we had during that period."

REITs outperform S&P 500
The report is bullish on REITs because they outperformed the broader market in 2001. The NAREIT Equity REIT Index last year posted a total return of 13.9% compared to a decline of 11.9% for the S&P 500. "For a two-year period ended in December, REITs posted a total return of 44%, compared with an 11% decline in the S&P 500," the report says. "Reflecting this, REITs have garnered increasing attention from investors, particularly institutional investors."

Part of this increased investor attention was due to the addition of REITs to several of Standard & Poor’s benchmark indices, the report says. REITs now account for approximately 20 basis points of the S&P 500, 40 basis points of the S&P 400 Mid Cap Index and 60 basis points of the S&P 600 Small Cap Index.

AEW doesn’t predict significant earnings improvement until mid-2003 or early 2004, when economic recovery will result in employment growth, occupancy improvement and rising rental rates.

CMBS holds steady
The Commercial Mortgage Backed Securities market outperformed Treasuries and MBS during most of last year. "Reflecting this, demand for CMBS securities was strong enough to support a record $97 billion of new CMBS issues during 2001," the report says.

Despite expected rising default rates this year, AEW believes commercial mortgage-backed securities "should perform reasonably well during 2002." The rising default rates are predicted to occur as a byproduct of the Sept. 11 terrorist attacks. "The immediate impact was a devastating blow delivered to the lodging and travel industries," the report says. "This raised immediate concerns with CMBS investors, as approximately 8% of the commercial loans supporting the outstanding CMBS issues are secured by hotel properties." The lodging sector isn’t the only concern. Other property sectors also are showing signs of weakness. "Significantly weaker property market fundamentals are now apparent across virtually all sectors of the real estate market and meaningful declines in property cash flows and values are anticipated for 2002 and 2003," AEW found.