It is the best of times for investing in real estate. But, warns Emerging Trends in Real Estate 1998, if pension funds are not careful, they could experience a repeat of the early 1990s, which was the worst of times.
Emerging Trends is an annual report on the state of real estate, and is published by ERE Yarmouth and the Real Estate Research Corp. More than 150 leading investors, analysts, developers and pension fund advisers are interviewed. This is the 19th year of its publishing.
During the depths of the real estate debacle, "Stay alive until '95," was a sentiment on which many investors hung their hopes for a turnaround. That has been replaced by, "Everything will be fine in '99," according to Emerging Trends.
"On balance, we're optimistic about the next several years, but also caution investors to be more selective - especially in the suburban office, hotel and industrial categories," the report states. "Most development projects under way make sense given today's economic positives and sweet market timing.
"However, let's see if we know when to stop, or at least cut back, this time."
According to one real estate veteran interviewed for Emerging Trends, there is more money chasing deals than at the peak of the '80s market. Bids are exceeding asking prices, as a result of the excess capital.
A healthy economy, strong supply-and-demand fundamentals, public markets discipline and lingering memories all have contributed to real estate's rebirth and should keep performance strong, according to the report.
Economy boosts realty
The economy has been the biggest factor, the report said.
"A combination of low inflation and low interest rates continues to push corporate profits and business expansion," the report states. "If productivity gains and operating efficiencies can forestall a near-term recession despite a slowing of corporate profits, then real estate should continue to benefit."
Vacancies are decreasing, which results in rent increases, particularly in the office and industrial markets, according to Emerging Trends.
"Even if capital sources lose control and underwrite a development binge, it will be two to three years before office markets are impacted by new product," the report said.
"In the meantime, there's opportunity to lock in tenants at excellent rates."
Public markets discipline and pension fund memories will keep things in check, according to Emerging Trends.
"Stock analysts are definitely an invisible hand," it reported.
"If apartments are any indicator, the influence of public markets could help control development."
Apartment real estate investment trusts invested in markets that showed signs of softening were hammered earlier this year, the report notes.
Pension fund memories also will provide discipline.
"They're scrutinizing adviser strategies more closely than ever," the report states.
1st choice: CBD offices
Downtown office is the property type of choice, rebounding from its bottom-of-the-pack position just two years ago, the report said. At that time, Emerging Trends said downtown office buildings -or CBD, central business district - had home-run potential for those willing and brave enough to invest.
"Probably the best play in the office category is snaring high-finish downtown towers built during the '80s in suburban agglomeration markets like Dallas or in struggling cities like Philadelphia," the report states.
"Left for dead since then, these buildings will lease up as surrounding areas tighten."
Emerging Trends interviewees remain enamored of industrial warehouses, although an increasing minority warn of creeping vacancies in some markets as new product is built.
"Older space without big-box, high-tech features is most vulnerable," the report states. "But for steady cash-on-cash returns with some upside potential, industrials can't be beat."
Hotels a mixed bag
Hotels and apartments received sell recommendations from Emerging Trends. Resist retail, the report states.
"Hotels are a mixed bag," the report said. "Limited service properties are overbuilt and hurting.
"Full-service and luxury categories, meanwhile, record all-time highs for occupancies and room rates, and development engines are revving up to meet unserved demand.
"But the lodging category is extremely vulnerable to economic downturns, which always makes for high risk."
Apartments are viewed as chancier investments by the Emerging Trends respondents.
"After a decade-long trend that marked them as probably the best risk-adjusted returns in real estate, the sector has reached its cyclical peak and performance is leveling off," the report states. "It's a much better time to sell than to buy.
"Returns will be reasonably good, with rents and values trending upward, but multifamily lags compared to office, hotel and industrial," Emerging Trends said. "Development has bumped up vacancy rates, especially in higher-growth Sun Belt markets."
Retail ugly, scary
Retail, meanwhile, remains "ugly, even a little scary," the report said.
"If retail is bad now when the economy is rolling, what happens when a recession hits?
"It's the same old story: too many stores, outdated retailing concepts, obsolescent malls, changing consumer and demographic patterns, faltering suburban districts and encroachments by new electronic formats."
If an investor has to buy retail, make it grocery-anchored neighborhood centers or power centers, according to the report.
"The best opportunity bet is placed on well-located power centers with high-credit tenants, the top producers in their merchandising categories," states Emerging Trends.
"In general, power centers remain comfortably entrenched at the bottom of investors' buy lists: too many got built too fast and there aren't enough quality tenants to go around.
"Selective buyers could land some good properties as sellers bail out of the category."
Metropolitan areas that offer 24-hour lifestyles, combining multiple residential options, convenient retailing and entertainment, mass transportation and relative safety, are the place to be, according to Emerging Trends.
Top markets listed
The top markets are San Francisco, Seattle, Boston and Chicago. New York came out of nowhere, jumping to fifth place from 12th, a year ago.
The second half is rounded out by Washington, San Diego and Los Angeles - underscoring Southern California's economic recovery - and Minneapolis and Miami.
"Clearly, many traditional cities are enjoying a renaissance, while newer Sun Belt suburban agglomerations - without true urban cores and with only minimal mass transportation capacity - are losing favor amidst a certain degree of land use chaos," Emerging Trends states.
"All the high-flying, high-growth South/Southwest agglomerations have tumbled out of the Emerging Trends top 10," the report states. "Atlanta has dropped most precipitously, from first two years ago to 15th position this year."
Money is the oil that will keep real estate markets running smoothly, and Emerging Trends interviewees forecast the industry will be awash in investment dollars in 1998. Pension funds, REITs, commercial mortgage-backed securities, foreign investors and banks and insurance companies will be in full force, the respondents forecasted.
"Both equity REITs and CMBS have far surpassed $100 billion in total market capitalizations, coming from nowhere at the beginning of the decade," the report states. "REITs have blown through apartment, mall and hotel categories, challenging pension funds as the dominant equity owners of commercial properties.
"The real IPO action will continue to be in office, with insurance companies and pension funds selling product into new operating companies.
"Accretive strategies by existing REITs will lead to consolidations and voracious appetites for new income-generating product, including leased-up-and-running development projects."
Enter pension funds
Pension funds, muscled out of properties with high net operating incomes, will corner the market for underleased properties and will begin to consider development projects, states Emerging Trends.
"Most of the plan sponsors' doubts about real estate, leftover from earlier in the decade, have been substantially diminished by three years of tangible results, including returns from opportunity funds that have equaled those of the stock market," the report said.
Foreigners also are expected to be active in private equity real estate.
German and Dutch investors from Europe and Asian flight capital, particularly from Hong Kong, and Middle Eastern investors all will be players, the respondents said.
"The Japanese show no inclination to re-enter U.S. markets, although office and hotel properties bought at sky-high prices in the late '80s and never sold off are finally resuscitating," states Emerging Trends.
The debt side
On the debt side, life insurers, commercial banks and conduits are flooding borrowers with mortgage choices, according to the report.
"Banks are providing corporate lines of credit to REITs, and separately, doing construction lending again," the report states. "They figure the REITs, in turn, will buy up the completed development product, giving them lender exit strategies.
Conduits, or CMBS, have seen the demand for their securities explode because of the spread they yield over corporate bonds, according to the report. As a result, they are ratcheting up their lending and relaxing standards.
"We're certain that when we make a loan we can sell it," said a conduit manager interviewed for the report.
But underwriting standards are slipping in the competitive frenzy.
"Some bad loans are being made," Emerging Trends said. "CMBS quality is lowering, as investment banker offerings are routinely oversubscribed.
"We're testing the limits."
It is just a matter of time before a hiccup occurs and a default happens in a some loan pools, according to the report.
"But not in 1998, and not enough to derail a firmly established new lending sector that so far has been highly profitable for investors and bankers alike," states Emerging Trends.