Hotels and downtown office buildings in selected markets offer the best return prospects of any property type in 1995, but pension funds probably will miss the opportunity, a new report says.
Pension funds, the report says, tend to move with the pack, and few dollars as yet have flowed into hotels and offices.
The report - Emerging Trends in Real Estate: 1995 - also said pension funds will begin to buy suburban office buildings, an out-of-favor property type that already has begun its rebound from a steep decline in the late 1980s and early 1990s.
A real estate industry forecast, Emerging Trends is published jointly by Atlanta-based Equitable Real Estate Investment Management Inc. and Real Estate Research Corp., Chicago.
More than 100 interviews were conducted with representatives from pension funds and their real estate advisers, insurers, commercial bankers, academicians and researchers and real estate investment trust executives.
For the second consecutive year, pension funds executives expressed optimism about real estate. More than 85% of Emerging Trends' pension respondents said they would invest in real estate in 1995, up from 81% last year.
Improving fundamentals in several markets and diminished returns for stocks and bonds make real estate a more attractive investment. Also, capital has returned in the form of private companies going public with Wall Street's help, and of increases in originations and refinancing of commercial mortgages from banks and insurers.
But Emerging Trends continues to "preach relative restraint and caution."
"The leading-edge Wall Street money is extremely fickle, and could pull up stakes without much notice if moved by unmet expectations or more seductive opportunities," the report states.
"Already the apartment and industrial sectors - the best-performing property types - are overheating in places," the report states. "Retail investments look riskier, and urban America's ills threaten certain office markets with protracted decline.
"This once very private industry continues its bumpy evolution into an asset class governed by the public markets and institutions," the report states. "It won't be clear sailing for investors."
Though REITs were the predominant story in real estate in 1994 - with many pension funds adding a component to their portfolios - pension funds still prefer direct, preferably unleveraged, property ownership, the report states.
"This is especially true for the large public plan sponsors, which have huge appetites for deals that can enhance their overall portfolio asset mix," the report states. Though diminished in number, open-end commingled funds remain an important vehicle for pension funds interested in diversification across property types.
"But pension investors increasingly prefer accounts that, like the private REIT format, give them more governance and control as well as the appearance of greater liquidity,"
The issues of liquidity and discretion, however, are now less significant than during the days of market gridlock, according to the report. Also, pension funds realize that to make deals today, their advisers must act quickly. But in large transactions for single-client accounts, plan sponsors are retaining the final decision-making authority.
According to Emerging Trends, industrial, suburban office and apartments are the property types of choice for pension funds in 1995. Regional malls are too big, unless the buyer is a large public fund. Any purchases by pension funds of retail likely will occur through open-funds or mall REITs, the report said.
"In general CBD (cental business district) office is off their scope," and "unlike other investors, pension funds show little enthusiasm for hotels - it's too capital intensive and specialized a business for their stomachs."
During a six-month period in 1994, REITs and pension funds bid up industrial prices to levels approaching replacement costs, according to the report.
"Bargains are scarce, product is thin and development is gearing up in some areas," the report states. Industrial is "clearly the preferred property category."
"But as Emerging Trends underscored last year, industrials are getting riskier because of technology's substantial impact on distribution strategies and the use of warehouse space.
Apartments also are approaching the top of their cycle, according to Emerging Trends.
Development is beginning in several markets, and it wouldn't take too many new apartments to upset the equilibrium, according to Emerging Trends. Though apartment fundamentals continue to be sound, "prospective buyers are advised to back off temporarily," the report states.
The days of mass marketing are over, and as a result, retail is being turned on its head, according to Emerging Trends.
Distribution channels have fragmented; security at shopping centers is an issue; consumers' real income has stagnated; and future population increases are not occurring in the middle- and upper-income households, which formed the backbone of mall sales.
"For all these reasons, investing in retail real estate has become riskier," the report states. Some "15% to 20% of the regional malls in business in 1990 will be closed by the end of the decade."
"Most will fail because owners would not or could not invest enough to keep them from becoming obsolete," the report states.
In order to be successful, retailers and mall owners need to appeal to varying demographic markets - particularly the growing minority and immigrant groups that will account for 75% of population growth over the next quarter century.
"The best retailing opportunities are in suburban growth centers with expanding industries - particularly in the Southeast and Southwest," the report states. "Hotbeds include areas around Atlanta, Charlotte, Raleigh, Orlando, Miami-Fort Lauderdale, Dallas and Phoenix."
Having bid up industrial and apartment prices, real estate investors are now turning their attention to suburban office buildings, according to Emerging Trends. The best-performing office markets will be the ones that are - or are close to being - "24-hour environments."
According to Emerging Trends, a 24-hour city doesn't close down at 5 p.m.; it contains prime residential areas and affordable housing, effective public transportation and convenience to commuter highways.
"These trends favor suburban markets and certain well-diversified older cities," the report states.
"Mature cities with the best prospects - San Francisco, Boston, New York, Chicago, Washington D.C. - all struggle with urban decay," the report states. "But they should endure because of their formidable around-the-clock engines."
The big losers, the report states, are the "eight-hour" business districts in cities beset by endemic poverty and poor mass transportation.
"Downtown office is improved but still sick," the report states. "Prices and yields are stabilizing while value declines are ending after precipitous erosion.
But offices with potential may be scarce, the report predicts, because owners who have held on this long may be inclined to wait for the recovery.
Hotels are finally having their day. As an industry, hotels are profitable again for the first time since 1981.
According to Emerging Trends, hotels are now attractive because Wall Street and other investors have exhausted opportunities in apartments and warehouses and are looking for an untapped property type; yields are attractive because hotels have fallen so far; and occupancies and room rates are rising.
"Will pension funds follow?" the report asks. "Not yet," according to the pension executives surveyed. The other interviewees expect sizable value gains for hotels in 1995 and give them the best long-term appreciation prospects among the property types, according to the report.