As 2002 limps across the finish line, the men and women who run the commercial real estate industry are looking to the Middle East for hints of what 2003 will bring. Industry execs agree on two points: The U.S. is all but certain to wage war against Iraq, and until that conflict is resolved the economic recovery won't gain any substantial momentum.

For now, the state of the economy is not inspiring great optimism in real estate circles. Gross Domestic Product rose 5% in the first quarter of 2002 and cooled to 1.1% in the second quarter. While the upward revision of third-quarter GDP to 4% was encouraging, economists expect it will rise by only 2% in the fourth quarter.

Job growth, the more important statistic for the industry, is still non-existent nationally, says Dr. Rajeev Dhawan, an economist with Georgia State University in Atlanta. Even as overall employment rates stabilize, corporate layoffs continue. Outplacement firm Challenger, Gray & Christmas reports that U.S. companies cut 176,010 jobs in October, second only to January's total of 212,704 layoffs.

“In early summer, it looked as if the national economy would pull through in terms of job growth, but it stalled in the fall,” says Dhawan. “The culprit was the uncertainty regarding a conflict with Iraq that brought capital spending to a halt. This also affected the confidence of the consumers, which dropped sharply in recent months.”

Investors Undaunted

Buyers of office properties, however, appear to be unfazed. Investors have been paying record prices for premium properties, despite falling rents and rising vacancies. Boston Properties' recent acquisition of 399 Park Avenue for $1.06 billion, or $630 per sq. ft., illustrates how attractive Class-A, well-leased buildings in prominent CBDs are to investors. When the building went to market last summer, bidders quickly drove the price up into nose-bleed territory.

Other Manhattan properties also have fetched unusually high prices in recent months. Another Midtown office building, 717 Fifth Avenue, sold for $611 per sq. ft. in October. Both buildings boast credit tenants and low vacancy rates.

And money continues to pour into real estate, because of the superior returns in comparison with other investment vehicles. Through September, the Nasdaq Composite was down 40%, following a 21% drop in returns for 2001. “It's going to take a lot to erase that memory,” says William Maher, director of North American investment strategy for LaSalle Investment Management in Baltimore.

By comparison, The National Council of Real Estate Investment Fiduciaries (NCREIF) Index — which tracks returns on about $100 billion of pension-fund owned real estate, excluding new construction and renovations — is up 5.6% over the past 12 months, says Maher. He anticipates 5% to 6% returns in 2003, too.

Pension funds plowed about $13 billion into real estate in 2002, a figure Maher expects to rise to $14 billion in 2003, says Maher. He recommends that low-risk investors “underweight” their holdings in office, “overweight” their holdings in industrial and retail and hold the line on apartments. “The reason we like industrial is that the rents never spiked as much as they did for office,” says Maher. “There isn't as much downside potential.”

Still, the charmed life of the real estate sector — strong returns and record sale prices in the face of deteriorating fundamentals — could end in 2003. For starters, most industry experts foresee rising interest rates in the new year, which would dampen investor enthusiasm for the office and multifamily sectors.

Over the next 12 pages, NREI presents a forecast for the office, industrial, retail, hotel and multifamily sectors. We kick off our coverage with industry icon Sam Zell, chairman of Equity Office Properties Trust and Equity Residential Properties Trust. The always-opinionated Zell remains an optimist.