The real estate market in 1996 is a little like the rookie football player, who, fresh out of college, signs a multimillion-dollarand for a moment thinks that life over the next few years will be expensive cars, expensive clothes and expensive women. The fantasy is quickly dampened as his agent warns him that bad spending habits have financially ruined more than one high-priced star.
Real estate markets have reached that critical point, says the cautionary Mary Ludgin, a managing director at Heitman/JMB Advisory Corp., Chicago, "where abundant capital is available, and as a result, even more discipline is required."
The last two years were comeback years for the real estate industry. In many asset classes, fundamentals have returned to order as vacancies drop and rental income increases. Meanwhile, real estate values are still relatively low stemming from the deep recession at the end of the 1980s and beginning of the 1990s.
The combination of the improving fundamentals and low values has been overwhelmingly attractive to investors, financial institutions and almost anyone else in the real estate business.
Capital suddenly is no longer a problem. Banks want to give it away. Wall Street can still manipulate it. Pension funds and other institutional investors seek to invest it. Opportunity funds can raise it. Even developers unexpectedly found they are able to get their hands on it. In 1995, "it" attracted a lot more of "it."
The memory of the 1980s, however, is still in the minds of many real estate professionals. Back then, real estate markets were flush with capital; buildings sprouted like weeds in a back alley; investment dollars seemingly grew on trees but, just a few years later, the whole industry wilted away.
The 1990s investor needs to be more careful than ever as to where to place capital. Real estate is cyclical, but not all spokes in the wheel are cyclical at the same time.
Over the past two years, real estate investment trusts, conduits and multifamily housing all went stratospheric only to run short of fuel. To paraphrase the 1996 Landauer Real Estate Market Forecast, the real estate community is naturally skittish.
And Emerging Trends In Real Estate 1996, published by Atlanta-based Equitable Real Estate Investment Management and Real Estate Research Corp., Chicago, reports, "This year's Emerging Trends remains bullish about real estate returns, but counsels continued caution and restraint."
B.K. Allen, president of Vienna, Va.-based B.K. Allen Real Estate, agrees: "In general terms, investors in 1996 should be patient. Funds invested in real estate should be `patient' money." She continues: "Speculators who constantly chum' property frequently get themselves into trouble. In other words, don't invest in any property you do not intend to own at least three years."
Allen also says, "Suburban markets are going to be more viable, economically, than urban areas. Locations surrounding international airports will continue to hold excellent promise for investors."
What will it take to be successful in the real estate business in 1996? Rick Abraham, president of Koll Management Services, which is based in Chicago, suggest five things: opportunism, selectivity of investment, application of technology, application of economies of scale and, for those where the issue is relevant, international involvement.
Sure, 1995 was a comeback year, Abraham says, but in actuality it was a "pockets of comeback year." Generalities don't work. Some REITs liked self-storage and hotels looked good, while retail REITs slipped; suburban office markets came back, but downtown markets remained sluggish. In 1996, it will be important to know the details.
About two years ago, Equitable Real Estate Investment Management Inc. in Atlanta launched its Value Enhancement Fund, which eventually acquired more than $500 million in real estate. It was successful enough that the company decided to come back with Value Enhancement Fund II, which will close out this year after raising $250 million, and like its predecessor, the objective is to find unique investment opportunities that carry a bit of lease-up risk. Although the fund will carry retail and industrial, it is mainly targeting suburban and downtown office buildings.
"The vulture opportunities for office are over, but there are plenty of opportunistic deals," says Paul Dolinoy, senior executive vice president for Equitable Real Estate, "especially where the buyer is willing to take the leasing risk, because the building either has a big chunk of vacancy or shows a lot of near-term lease expirations."
There are plenty of deals for opportunistic buyers, Dolinoy reiterates, because there is a lot of capital chasing core investment properties, including the Class-A suburban and downtown office space with not a lot of leasing risk.
The office market showed a 7.07% return for the one-year period ending Sept. 30, its highest return in over a decade I reports Tony Fiacchi, director of Data Services for the National Council of Real Estate Investment Fiduciaries (NCREIF) in Chicago. "It is reasonable to expect by the end of 1996 for total returns for office to be up in the double digits, maybe around 10% to 11%
While office has shown slower improvement than other sectors, with almost no new construction in the past three years, the national vacancy rate has declined from a peak of 24% to 15%. Sixteen of the top 100 markets in the United States are already showing vacancy rates in the single-digit category, while another 10 markets should join that list in 1996.
The change in fortunes in the office market is due to improving supply and demand characteristics. According to Dr. Peter Linneman, director of the Wharton Real Estate Center at the University of Pennsylvania and head of the Rockefeller Center REIT, supply is growing at 0.75%, while demand has been improving at 1.5% annually, which means the office market is getting healthier but at a moderate pace. "Vacancy rates will continue to improve," Linneman says, "but not as fast as over the last three years."
This view is echoed by David Hensley, a vice president at Salomon Brothers in New York, who says: "The favorable increasing occupancy trend should continue in the year ahead, although the gains will be less impressive compared with those logged in the past few years. The pace of supply growth is creeping higher, whereas office job growth is slowing with the overall economy." Hensley predicts in the year ahead, the biggest occupancy gains likely will occur in such Florida and Texas cities as Tampa, Orlando, Fort Lauderdale, San Antonio and Austin. The worst performers likely will include Orange County and San Jose, Calif.; Honolulu; Columbus, Ohio; Rochester, N.Y.; and New Haven, Conn.
Industrial real estate remains in favor with institutional investors, reports the Real Estate Research Corp. (RERC). According to a recent RERC survey, 59% of institutional investors believe it is a good time to buy warehouse properties, while only 25% say it is time to sell.
There is good reason for the optimism. As NCREIF's Fiacchi points out, warehouse properties have outperformed, in terms of income returned, all other property types in 1995. "This trend easily is expected to continue through 1996, yielding a year-end return somewhere in the vicinity of at least 15% -- and that's conservative."
Returns have been good because the industrial market, which was not as badly out of whack as office, has continued to improve. Since peaking at 10.7% in 1991, vacancy has declined through mid-1995 to 8% -- a level not achieved since 1987, says Ludgin of Heitman/JMB.
The long-range forecast for industrial is very strong, says David Birch, president at Cognetics in Cambridge, Mass. "Even our most conservative estimate for the need over the next 10 years equals that for the 1985-1995 period -- about 4 billion new square feet."
Birch says the two regions that will dominate the need for space are the "Rust Belt" states, Ohio, Indiana, Michigan, Illinois and Wisconsin, and the entire Southeast.
In the short run, however, Heitman's Ludgin says when considering the industrial market, investors should consider the following points:
* A continuation of a conservative lending environment, which should limit the development of speculative industrial space;
* Further improvement in occupancy and rents;
* Increasing supply, but no widespread overbuilding;
* Continued capital commitments by investors; and
* Emergence of smaller distribution markets (As U.S. businesses improve efficiencies in the way they handle and store goods, a number of smaller distribution markets such as Indianapolis, Nashville and Cincinnati have emerged to challenge the traditional regional distribution centers such as northern New Jersey and Los Angeles).
"Multifamily is a good barometer for a lot of the cynicism about new development," says Ray D'Ardenne, an executive vice president at Equitable Real Estate, Atlanta. The problem for multifamily is that it has already done what everybody epected of it. The fundamentals came together in the market about three years ago, and that fueled a significant development program in 1994 and 1995. That development is already slowing as a lot of developers around the country, including some of the biggest ones, are pulling in their horns.
Also pulling in their horns have been the apartment REITs, which had been on a buying spree that ended in 1995. However, some of the slack is expect to be picked up by pension funds, almost all of which are under-weighted in multifamily. "It's important to understand the nature of pension funds, which are long-term investors," D'Ardenne says. "While many feel that over the short term, the outlook for returns on apartments may not be as bright as it was in the past, long-term players feel comfortable having this asset class in their portfolio."
Actually, not everyone is so down on multifamily in the short term. Fiacchi of NCREIF says yearly returns on the class in 1996 will be in the low to mid-12% range, which will b composed of slightly upward drifting income of 9.3% to 9.5% and capital appreciation of 2 .5% to 3%. "I still see it as a strong sector," says Linneman. "Not a boom sector, just a solid sector where supply is basically keeping pace with demand growth. There won't be lots of vacancy or spikes in rent."
According to Equitable's Emerging Trends, there are numerous niche opportunities in multifamily. One opportunity is in high quality apartments, which are marketed to: empty-nesters, aging baby boomers, single-person households, couples without children and people working from home. Affordable housing also offers opportunity, because there are fewer high-paying jobs for blue-collar workers, fewer people can afford homes. In addition, expanding minority and immigrant populations foster an increasing need for more affordable housing. A third area of opportunity is senior housing developed in typical apartment-style units in a community setting with food service, planned activities and attached medical or nursing home facilities. In this sector, however, it is better to invest with someone who knows how to manage these kinds of properties.
"After a long run as the darling of professional investors, shopping centers find themselves eclipsed by the gathering strength in other commercial property sectors as we enter 1996. It is a reminder that cycles are the dominant fact of life in the real estate business," notes Landauer's Real Estate Market Forecast.
Over the past year or two, the performance of companies that tenant shopping centers has made investors nervous about this sector. Not only have their been innumerable mergers, mostly among department store chains, but a number of old-line retailers such as Jamesway, Caldor and Bradlees aU entered bankruptcy in 1995. On top of all that, the performance of Kmart, one of the country's largest retailers, has not been good, and it has been closing stores.
"1996 and 1997 are going to be years of sorting out the winners and losers in retail and whether everybody voids their lease or keeps their lease," says Linneman. "Real estate investors want to know that despite bankruptcies, their properties will be OK."
The turmoil in retail is reflected in returns, which have been very weak. As NCREIF's Fiacchi notes, "We may not expect anything too terribly earth shattering on the return scene for retail in 1996." Total returns may run in the 6% to 6.3% range, he says.
Some analysts find the turmoil in this sector means it is ripe for investment. "There are going to be buying opportunities in regional malls as well as with certain retail REITs, because the market has overreacted to the retail environment and to some of the bankruptcies," says Robert Blumenthal, managing director of Bankers Trust Real Estate Investment Banking Group in New York. "A lot of the retail REIT stocks have been severely discounted, and that discounting does not reflect the true value for buying opportunities."
Blumenthal adds, "A lot of regional malls don't have the Caldors or the Bradlees, but they do have Penney and Sears, both of which are doing well."
Stan Ross, vice chairman and managing partner of Los Angeles-based E&Y Kenneth Leventhal Real Estate Group, says this segment will not crash. "Retailing is going to be re-designed and re-engineered."
The country's large credit debt, Bosnia and other factors weigh heavily on sales volume, there is a much more important shift going on in the retail industry. "Retailers are taking a more sophisticated approach than in the past, analyzing and re-analyzing their options -- rehab, reconfigure, restock, expand, consolidate," says Ross. "The current trend of joint venturing or incorporating entertainment themes is only the beginning of what I feel will be a seminal change in the industry itself."
Just before 1995 ended, Colony Capital Inc., a Los Angeles-based international private-investment firm and one of the largest buyers of real estate in this decade, swooped down on the big island of Hawaii and acquired the 539-room Ritz-Carlton for $75 million. The property had been taken back by a Japanese bank in lieu of foreclosure. Just two years before, an affiliate of Colony Capital also bought, from a Japanese lender, the Hyatt Regency Waikoloa just a few miles from the Ritz-Carlton. The purchase prices were estimated to be well below original cost to build.
Although the resurgence of the hotel sector has been dramatic over the past two years, lingering effects of the real estate recession, especially in the luxury market, has meant there are still buying opportunities.
"If you look at the economics of what it costs to build a full-service hotel or build a major convention hotel, you are still better off buying a property. Values are recovering for existing properties," says Robert Mandetbaum, director of research at PKF Consulting in San Francisco. However, he adds, for those that want to build, the best place to be is in the limited service sector. That's an interesting point, because the excellent performance of the hotel business over the past two years has made some developers itch to get back into the construction game again. The lodging industry is, however, highly segmented, which means demand can be strong in budget but less so in the higher end product.
E&Y Leventhal's Stan Ross agrees. He says his company's specialists see a slowdown in the upper end, but activity will continue in the limited-stay and extended-stay bargain hotels in 1996. "Multi-branding -- multiple names for hotels owned by the same chain -- will continue to target diversified needs of guests, and the potential for overbuilding continues to grow as well."
New construction recently has been prevalent in the budget and economy end of the industry, but Bjorn Hanson, national industry chairman of lodging gaming at Coopers & Lybrand in New York, reports growth demand is actually strongest in the mid-price sector. Last year there were 69,500 room starts, a major jump from two years before when room stars were at 32,400. Room starts will probably slow somewhat in 1996 to 61,400, but there will be a strong mix to all segments.
While the lodging market is doing well, Hanson notes some cautions for investors and developers:
* It may not yet be the time to build. Demand and occupancy are growing rapidly, but in the mid-price sector, for example, hotels are still being sold at 74% of replacement cost. It is still cheaper to buy than to build.
* Franchise agreements are problematic. Management and franchise agreements are still as negotiable as they were back in 1991, arguably the worst year for switching. Investors should expect to be able to negotiate heavily on management and placement fees.
* There is a savvy traveling public. Today's traveler is a lot smarter about finding the best room rates and/or negotiating the best services for the best price.
The cautions are needed to temper the enthusiasm being generated by lodging industry performance. Last year was the most profitable year in lodging industry history, with profits more than 3.7 times the inflation-adjusted profits of 1979. And the industry is not expected to slow down.
"One of the things we are projecting for 1996 is almost record-setting profit margins," says Mandelbaum. "We are seeing profit margins reaching 25%."
Hanson saves profits will be up 20% in 1996. Aggregate industry profits were $7.9 billion in 1995, and that should improve to $9.5 billion in 1996. Profits per available room reached $2,445 in 1995, and that will move up to $2,884.
However, not everything is so sanguineous in the lodging industry. The gaming sector could be a real gamble in 1996. "Gaming could be the next bust," says Roger Johnson, national director of KPMG's real estate practice in Chicago. "And we are beginning to see that with some river boats and landbased casinos in New Orleans." He say: "I'm concerned that we have reached a point in gaming where we have attained saturation. I am talking about the non-Las Vegas stuff. It is an area investors should approach with healthy caution."
Last year Equitable Real Estate Management doubled its transactions for pension clients over 1994. "The momentum will continue and the opportunities will be there in 1996," says James O'Keefe, CEO of Aetna Realty Investors Inc., New York.
"Last year was a record year for us for new business," says Jonathan Kern, senior vice president with J.E. Robert Cos., a Tysons Corner, Va.-based real estate investment advisory firm. "We did more last year than the year before, which was somewhat surprising, because we tend to specialize in opportunistic situations and, at the beginning of the year, it seemed there would be fewer deals. In 1996, 1 see business continuing to be very good."
The real estate markets will be strong this year, Kem says, because a number of trends that began in 1995 will continue in 1996:
* Opportunity funds. Many of the opportunity funds that raised - or were in the process of raising money - in 1995 experienced significant success. Much of that money was put into play in 1995, but more of it will be invested in 1996.
* Bigger is getting better. There is an increased willingness by investors to commit to larger projects, such as Rockefeller Center.
* Less distressed debt. There was a scarcity of the truly distressed debt that used to be in the market from the S&Ls and the Resolution Trust Corp. On the other hand, better quality real estate -- though still underperforming - has come to market.
* Equity over debt. Institutional investors are investing directly in real estate as opposed to debt.
* Japanese assets. The Japanese banks are saying they absolutely will sell, and they need to sell. Eighteen months ago, it was commonly thought the japanese would not sell at "realistic" prices, but that hasn't proven true at all.
For investment money, the risk is demanding reward, says Linneman of Wharton Real Estate Center. "There was a time in the 1980s when real estate had risk and wasn't giving rewards, but most people pretended it did. The 1990s are almost the opposite. Risk today is demanding a return. If you want to earn a dollar, you have to take a dollar's worth of risk."
According to Emerging Trends in Real Estate, the real estate appreciation component of investment portfolios is expected to keep and generally outperform inflation for five- and 10-year periods. If typical 7% to 10% annual income returns are tacked onto appreciation estimates, "most real estate portfolios will enjoy annualized returns in the low double-digits during the next decade."
Pension funds, which did well in stocks and bonds in 1995, are finding their allocation to real estate has grown smaller, not larger. "Although pension funds invested a higher dollar amount in real estate last year, they ended up with a lower percentage of real estate when the numbers came in," says O'Keefe of Aetna Realty. In 1996, pension funds will probably work harder at keeping allocations to real estate at a larger percentage than in the past.
Ross of E&Y Leventhal says, "If investors want a pure interest rate and longterm bond rate return, they can go to mortgage bonds, ONMAS, which are real estate, or FNMAS, which are government guaranteed and protected with long-term interest rates tied to the Treasury." Ross also says if investors are willing to take more risk for higher returns, then they can look at mortgage-backed securities dealing with subordinate loans.
One cautionary note from Emerging Trends is that the evident market realities provide a considerable challenge to investor analysis, and a premium is placed on marrying information flow - economics, markets, demographics - to the transaction process. "Investors want performance, not psychic value or trumped-up pipe dreams."
The ability to marry divergent sources of information, if not to find a convenient way to receive and store this information, has plagued the real estate business. An abundance of information in other asset classes such as stocks and bonds, for example, has made for stable and well-run markets. In comparison, real estate markets appear chaotic. "The availability of better technology allows us to provide more detailed reporting to our institutional and corporate clients on a more rapid basis," says Mary A. Marx, senior vice president of management services at The Voit Cos. "However, this has become a dual-edged sword as the clients now require property management firms to purchase the newest systems and transition reporting onto these systems as quickly as possible."
"Everyone recognized in real estate that part of the problem was lack of information," says Brian Webb, managing director of research at Aetna Realty. "Information vendors realized there is money to be made by providing this information to investors. As a result, they have come out of the woodwork and are doing a much better job of delivering information."
Ross of E&Y Kenneth Leventhal agrees that more information is needed in the real estate business. "Those real estate companies that continue to believe that proprietary rather than shared information provides the competitive edge will be dinosaurs by the century's end."
Last year seemed to have been a turning point for technological innovation in real estate as a number of vendors and service-providers announced new products for the marketplace. Among the many announcements were:
* Teleres, a joint venture between Dow Jones Co. and Aegon, a Dutch investment company, plans to unveil an online information and analysis system. The aim is to provide a source of comprehensive data, online information and analytic tools, all with the purpose of standardizing the process for trading, rating and valuing commercial real estate.
* Copley Real Estate Advisors says it has invested $2 million to $3 million in a proprietary system that will help the company better manage portfolios and assets. Eventually, all of Copley's clients will also be able to access the system online.
* Grubb & Ellis announced the creation of the Enterprise Network, a technology-driven communication and information system that will connect all of its offices and brokers via voice and computer.
* InmanFeatures and Becky Swann's Internet Real Estate Directory, two online service-providers, announced the formation of "i news," a new consumer resource designed to be the nation's largest and most accessible independent real estate information resource and Internet traffic guide.
* National Association of Realtors unveiled Realtors Information Network, an online service for industry members. "Technology will revolutionize how and where companies can best do business over the next five years, creating far-reaching change in the type and location of real estate demand," says Gary Lenz, worldwide director of Arthur Andersen's Real Estate Services Group, Los Angeles.
"The information age is changing the way people live, work, shop and play," says Lenz. This will affect the real estate industry in every part of the global because technology gives corporations greater flexibility and choice in headquarters locations and allows them to be more productive with fewer people. It is not bound by geography, which will create real estate demand, and it has introduced a new medium for business transaction, meaning physical space is no longer the only place to do business. Technology is redefining real estate development in the 1990s.
"The real estate industry will no longer be behind the techno-curve in the months to come," says Ross of E&Y Kenneth Leventhal Real Estate Group. "The drive for more process improvement in how real estate companies operate portfolios, do deals, manage properties and conduct analysis is being revolutionized by new technologies."
Ross also says that another area of trouble for real estate is the online and Internet-based real estate information and analysis efforts. "1996 will see the debut of the first commercial real estate dedicated online system (Teleres), and the Internet is already hosting activities like RealPage, a new 'office building-like' network of real estate home pages."
As for software, Ross says, "I wouldn't be surprised to see an investment offering to create a real estate version of Microsoft, perhaps by the end of 1996."
"As we enter a world of virtual time and space," Lenz concludes, "technology will create 'haves' and 'have-nots' in every aspect of real estate from Singapore to Prague, from New York to Buenos Aires."
According to Ross of E&Y Leventhal, no legislative changes could impact real estate more than the flat tax. "A flat tax would dramatically affect deductibility of interest on capital and debt raised, as well as depreciation and expensing."
He notes that the current budget reduction bill contains a new investment vehicle that could create even more investment capital for real estate. Asset backed securitization, a business that has grown to over $100 billion issuance in 1995 alone, is about to get a big boost from Congress, says Ross. The new vehicle -- the Financial Asset Securitization Investment Trust (FASIT) -- will be able to securitize all types of debt instruments. "Many people feel that FASITS will have the same kind of impact on credit markets as the REMIC mortgage-backed securities - lower borrowing costs to consumers and diversification of investment risk," says Ross.