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Executive Summary and Preface

Chapter 1 The Race Is OnSteady-Eddy PerformanceBye-Bye Low Interest RatesMore Secular Than CyclicalThe Economy: Modest GrowthJobs QuandaryDare We Mention Offshoring?Disappointing DemandCommercial Development CheckedHousing SplurgeShifting Lifestyles, Changing Developer FocusGlobal Uncertainty Shadows the Markets

Chapter 2 Investment Trends 2005Pay Up or Sit on the SidelinesTempered Core ExpectationsOpportunity Stays Offshore Best Bets 2005

Chapter 3 Real Estate Capital FlowsCapital Trends: Equity Players Capital Sources and Flows Capital Trends: Debt Players

Chapter 4 Markets to WatchGlobal Gateways Strengthen Follow the Crowd Halo Effect Hot Growth Markets CoolHomebuilder Choices Mimic Investor PreferencesThe Best and the Rest

Chapter 5 Property Types in Perspective Coupon Clippers FavoredDevelopment: Commercial Blahs, Housing FervorIndustrialRetail Apartments Office HotelsHousing

Interviewees/Participants

ii Emerging Trends in Real Estate® 2005

Editorial Leadership TeamEmerging Trends ChairsPatrick R. Leardo, PricewaterhouseCoopersRichard M. Rosan, Urban Land Institute

Author/EditorJonathan D. Miller

Principal Researchers and AdvisersStephen Blank, Urban Land InstitutePeter F. Korpacz, PricewaterhouseCoopersSteven P. Laposa, PricewaterhouseCoopersDean Schwanke, Urban Land Institute

Senior Adviser and PublisherRachelle L. Levitt, Urban Land Institute

Senior AdvisersNick Cammarano, Jr., PricewaterhouseCoopersRobert K. Ruggles III, PricewaterhouseCoopers

Contributing ResearchersSusan M. Smith, PricewaterhouseCoopers Richard Kalvoda, PricewaterhouseCoopers John Rea, PricewaterhouseCoopers

Editorial and Production Staff Bernadette T. Korpacz, Project CoordinatorNicole Witenstein, Data ManagerNancy H. Stewart, Managing EditorDavid James Rose, Manuscript EditorByron Holly, Senior Graphic DesignerDiann Stanley-Austin, Director of Publishing Operations

Emerging Trends in Real Estate is a registered trademark ofPricewaterhouseCoopers LLP.

© October 2004 by ULI–the Urban Land Institute andPricewaterhouseCoopers LLP.

Printed in the United States of America. All rights reserved. No part ofthis book may be reproduced in any form or by any means, electronicor mechanical, including photocopying and recording, or by any infor-mation storage and retrieval system, without written permission of thepublisher.

Recommended bibliographic listing:ULI–the Urban Land Institute and PricewaterhouseCoopers LLP.Emerging Trends in Real Estate 2005. Washington, D.C.: ULI–the Urban Land Institute.

ULI Catalog Number: E21ISSN: 0-87420-934-X

Emerging Trends in Real Estate® is a trends and forecast publicationnow in its 26th edition, and is the most highly regarded andwidely read forecast report in the real estate industry. EmergingTrends in Real Estate® 2005, undertaken jointly by ULI andPricewaterhouseCoopers, provides an outlook on U.S. investmentand development trends, real estate finance and capital markets,property sectors, metropolitan areas, and other real estate issues.This year’s report features expanded coverage of the housing indus-try, a variety of specialty and niche property sectors, and trends ininvestor site/location preferences.

Emerging Trends in Real Estate® 2005 represents a consensus outlookfor the future and reflects the views of more than 500 individuals—arecord-breaking industry response—who completed surveys or wereinterviewed as a part of the research process for this report. Inter-viewees and survey participants represent a wide range of industryexperts—investors, developers, property companies, lenders, brokers,and consultants. ULI and PricewaterhouseCoopers researchers person-

Emerging Trends in Real Estate® 2005 1

■ Improvements in supply/demand fundamentals race against ris-ing interest rates. Interviewees are cautiously optimistic that mod-est economic growth will sustain values and steadily improve rev-enues. By 2006, higher interest rates could slacken frothy pricinglevels, if the economy continues to struggle to create enough newjobs to help advance leasing and increase property cash flows.

■ Over the next cycle, performance expectations continue to ratchetdown to high single digits for seasoned core portfolios—still relativelyattractive returns compared with volatile stocks and lagging bonds.

■ In 2005, owners should sell nonstrategic assets, taking advantageof strong capital demand, and leverage holdings before interestrates rise any further.

■ Pent-up demand from institutional investors helps sustain capi-tal flows and buttress values as leveraged buyers back off in a risinginterest rate environment.

■ Development remains controlled in most commercial sectors.Homebuilders stay in step with buyer demand, not ahead of it.

■ Traffic congestion and changing lifestyles impel more mixed-usetown center developments, urban mixed-use projects, and infill res-idential. Aging baby boomers drive unquenched demand for resortand second homes.

■ Delinquency and default rates will stay under control in 2005.REITs expand their dominance in institutional equity markets, and

CMBS conduit lenders continue to gain market share in the debtmarkets. Private investors back off when leverage strategies becomeless enticing, and pension funds increase activity to fill the void.

■ Bicoastal investing becomes more ingrained. The herd focuseson four primary markets: Washington, D.C.; southern California;New York City; and south Florida.

■ Sunbelt metropolitan areas face potential growth slowdowns astraffic and sprawl reduce their desirability. Their prospects contin-ue to hinge on developing successful 24-hour infill environmentsand integrating mass transportation alternatives to the car.

■ Some secondary and tertiary markets could struggle to remainrelevant as business and commerce increasingly cluster in majorhigh-profile cities linked to international trade, financial services,and technology.

■ Commercial investors will continue to favor coupon-clipper,income-producing property sectors—warehouses, neighborhoodgrocery-anchored retail, and moderate-income apartments. Alwaysvolatile hotels position to show the sharpest gains during the year.Office promises to lag.

■ Homebuilders face leveling demand—homebuyer appetitescould start to flag in the face of higher interest rates and risingconstruction costs.

Executive Summary

Prefaceally interviewed over 125 individuals (see the end of this report for alist of interviewees and participants) and survey responses werereceived from 413 individuals, broken down as follows:

37.3% Private Commercial/Multifamily Property Companiesor Developers

19.1% Institutional/Equity Investors or Advisers14.0% Publicly Traded Commercial/Multifamily REITs or

Operating Companies9.7% Homebuilders or Residential Land Developers9.4% Lenders or Mortgage Bankers/Brokers9.2% Real Estate Services1.2% Other

To all who helped via surveys or interviews, Pricewaterhouse-Coopers and the Urban Land Institute extend sincere thanks for shar-ing valuable time and expertise. Without the involvement of thesemany individuals, this report would not have been possible.

The The

“The race is on between

improving fundamentalsand rising interest rates.”

Real estate players tout their standing as the “largestrunt” in a litter of battered asset alternatives and revelin the wash of unprecedented capital flows searching for

relative value in property investments. While volatile stocksstruggle and bond markets lose appeal in a rising interest rateenvironment, uncomfortably high vacancies and compromisedcash flows have hardly diminished investor fervor for real estate.A flood of institutional and private buyers, some using gobs ofreadily available cheap debt, supports values. These investorswager that an inevitable economic rebound will cover theirbets. Considerable pension capital, meanwhile, waits on thesidelines for leveraged purchasers to back off, building confi-dence among many Emerging Trends interviewees that capitalflows can be sustained: “Real estate is the storehouse of wealth.”“It’s cycle-tested and now more respected by chief investmentofficers of the big institutions.” “Real estate is not sexy orromantic, but it has the attribute people want most today—income, steady and predictable income.”

At the same time, many veteran investors signal now is thetime to sell. “Anybody who is not a net seller in this market isnuts,” says an investment manager. “Pricing has been nonsensi-cal given the market conditions.” Adds a major pension fund


consultant: “I’ve told my clients to dispose of all nonstrategicassets.” A leading institutional broker warns that “pretty intelli-gent pros are not playing in the market.” “To make deals atsuch low cap rates with such poor market fundamentals you arethrowing caution to the winds,” says a syndicator. “No oneknows when markets are coming back.” Sums up a veteraninvestor: “It’s certainly a crapshoot.”

Steady-Eddy PerformanceThe next two years will probably determine whether restoredconfidence in the property markets has been well founded oroverplayed. Make no mistake, the race is on—can real estate sup-ply/demand fundamentals improve enough in 2005 and 2006 tooffset the potential negative impact of rising interest rates onproperty values and pricing? In turn, will enough job growth andeconomic improvement occur to help push down vacancies andincrease rents in the face of continuing geopolitical distress,uncertainty over terrorism, and related inflationary oil prices,which inevitably crimp consumer and business confidence?

c h a p t e r 1

is onRace

4 Emerging Trends in Real Estate® 2005

While last year’s interviewees cloaked 2004 outlooks in“cautious pessimism,” they seem resiliently “less bearish” inforecasting 2005 and anticipate a “soft landing.” Manyinvestors count their lucky stars that returns have held updespite poor demand drivers in all sectors, except consumer-fed retail, which has been a stellar performer. “Thank you, Mr.Greenspan.” Despite some nervousness over the economy andmarket imbalances, interviewees almost without exception areconfident that U.S. real estate markets can avoid scenarios thatwould crater property values. “Nothing catastrophic appears onthe horizon.” But they also forecast little opportunity for anyoutsized gains. Office, industrial, and apartment markets havestabilized with signs of more animated tenant demand; hoteloccupancies rebound finally after the fallout from 9/11, SARS,and the Iraq War; and the economy appears positioned formodest growth. Few respondents, however, anticipate a robusteconomic upturn.

“We’re embedded in a lackluster cycle,” says a prominentresearcher. Real estate has become a “yield play, not a greatstory.” Most observers continue to predict that seasoned coreproperty portfolios can record 7 to 9 percent total returns overthe next five- to seven-year cycle. Judicious dollops of leveragecould boost performance into the low teens. But recent invest-ments, purchased at rock-bottom cap rates, may face greaterhurdles, given rising interest rates and a mediocre recovery—“buyers should expect more like 5 to 7 percent total returns.”

Such “steady-eddy” real estate performance “should be quiteacceptable,” considering the anemic stock market run andsobering raft of monthly 401K statements. Increasingly sub-dued investment expectations across all asset classes should ben-efit real estate, especially on a risk-adjusted basis. “We’veentered a lower-return environment where real estate perform-ance will look increasingly positive,” says a mutual fund execu-tive. “Real estate will have a lower risk profile, generating mod-erate returns with lower volatility,” nestling comfortablybetween stocks and bonds on the risk/return spectrum. “It justmakes sense to take dividends from well-underwritten realestate when you look at the alternatives.”

Indeed, structural changes over the past ten years havearguably reduced risk and “mainstreamed” real estate investing,enhancing its relative value appeal. More information, research,

Modestly Poor 1.28%Outstanding 2.99%

Excellent 11.97%

Very Good 32.48%

Fair 7.69%

Good26.07%

“Increasingly subdued investment expectations across all asset classes should benefit real

Exhibit 1-1 Real Estate Firm Profitability ForecastProspects for Profitability in 2005 by Percentage of Respondents

Source: Emerging Trends in Real Estate 2005 survey.

Modestly Good17.52%

0Abysmal

5Fair

10Outstanding

Exhibit 1-2 Investment Prospects for VariousAsset Classes in 2005


Note: Prospects were rated on a total rate of return basis.

U.S. Private Direct Real Estate Investments

Asian Private Direct Real Estate Investments

International Equities

U.S. Equities

European Private Direct Real Estate Investments

U.S. Publicly Traded REITsand Operating Companies

U.S. Publicly TradedHomebuilders

U.S. Commercial Mortgage-Backed Securities

U.S. High-Yield Bonds

U.S. Investment-Grade Bonds

U.S. Money Market Funds


public market scrutiny, and timely comprehensive data havetranslated into increased transparency and more informed deci-sion making. “Nothing is sneaking up on investors anymore.”Greater confidence has led to increased capital flows, lookingfor consistent yield, which in turn has propped up values andreduced volatility.

For 2005, survey respondents predict that real estate will out-perform stocks (67 percent yes v. 33 percent no) and bonds (96percent v. 4 percent). They also forecast that private real estatehas the best asset class investment potential, ahead of domesticstocks and public real estate. (See Exhibit 1-2.) Worst-case sce-nario: if the economy tanks from an exogenous geopolitical cri-sis or terrorist-induced skittishness, Emerging Trends intervieweescalculate that property markets will suffer no greater declinethan stocks or bonds. In fact, long-term leases on hard assetsshould offer greater downside protection than stock or bondinvestments, which could immediately lose value in a marketdowndraft. From a relative value analysis, real estate should hold itsedge in a recession scenario, too. “Everyone would be disadvantagedabout equally,” suggests the consensus Emerging Trends wisdom.

Such misery-loves-company rationalizations aside, someinvestors who gorged on floating-rate debt to finance acquisi-tions have become increasingly vulnerable to any market dislo-cations that would spike interest rates or a tepid economy thatwould fail to generate enough employment and wage growth.The longer it takes for property market equilibrium to berestored, the greater the investor distress. With interest rates ris-ing, the stakes increase. Borrowers need to lock in fixed-ratedebt now before it is too late. Some opportunity players holdtheir powder in expectation of heightened foreclosure activity.“Then it might get interesting again.” While most investors willskate through, some overleveraged players may meet their reck-oning during the year.

For 2005, “it all comes back to interest rates, the economy,and job growth.” The race is on.

Bye-Bye Low Interest RatesIn recent editions, Emerging Trends highlighted how perform-ance would revert to the mean after the anomaly of thebust/boom 1990s, how strong recent performance has beensupported by twin crutches of historically low interest rates andprodigious capital flows, and how future returns would be com-promised in a “postponement effect,” because investors havealready anticipated recovery in their generous cap rate assump-tions, borrowing from the future.

In 2005, the interest rate crutch begins to pull away, dimin-ishing the acquisition appetites of leveraged private investors,who have been bidding up prices and sending cap rates skid-ding toward all-time lows. In the short term, most intervieweesexpect pent-up institutional capital to fill any void and sustainmarkets during the year. “So much money is supporting values,it looks better that improving fundamentals will have a chanceto catch up and offset increasing interest rates,” says a consult-ant. Gaping spreads between real estate yields and ten-yearTreasury bills offer additional cushion for investors. More pes-simistic interviewees suggest that cap rates will back up anderode values. A crunch could come in 2006 and 2007 if interestrates steadily increase and the economy plods along.

estate, especially on a risk-adjusted basis.”

–30%

–20%

–10%

0%

10%

20%

30%

40%

NCREIF

S&P 500

‘04*2Q

‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 1-3 Returns: NCREIF vs. S&P 500

Sources: National Council of Real Estate Investment Fiduciaries,Standard & Poor’s.

*Annualized figure.

“The period of easy credit and low interest rates has always been unsustainable and

No one disputes how low-interest-rate Novocain has dead-ened the pain of moribund tenant demand in the commercialmarkets. Thanks to low-cost leverage, private buyers bid up realestate prices and cash-strapped owners refinance mortgages,keeping vulture buyers at bay. In addition, the home refinanc-

ing binge—a result of basement-level mortgage rates—helpedto boost consumer spending and kept retail “red hot.”

The capital surge has affected cap rates paradoxically.“When fundamentals are lousy, cap rates should be going up.This time just the opposite has happened.” In fact, capitaliza-tion rates have been driven down to historic lows in apart-ments. Office and industrial cap rates are uncharacteristicallylow, given discomfiting vacancies and milquetoast tenantdemand. Sky-high power center and grocery-anchored retailpricing seemingly leaves little opportunity for more than bond-like returns under the best pro forma scenarios. “Low interestrates have had a huge impact, buttressing the value of our port-folios,” gushes an apartment developer/owner. “We’ve had agreat year despite poor fundamentals.”

But the period of easy credit and low interest rates hasalways been “unsustainable” and cannot paper over property-level shortfalls indefinitely. Now, rising interest rates are on “acollision course” with an economic recovery that has failed tocreate substantial momentum in the leasing markets. If improv-ing supply/demand fundamentals can advance property cashflows ahead of rising cap rates, then prices will hold up andincrease. If the reverse happens, prices and values will decline ascapital pulls back. Soon, the real estate markets will find out ifthey can stand on their own.

More Secular Than CyclicalEmerging Trends interviewees generally expect a modest, meas-ured advance in interest rates, managed judiciously by theFederal Reserve Bank. Many industry players express growingconfidence that the real estate risk premium has decreased in asecular shift arising from amplified capital flows, solid cyclicalperformance, enhanced transparency, and better image. “Caprates will be lower than in the past when investors paid a premi-um for our irresponsibility and unreliability,” says an interviewee.

But most respondents struggle over recalibrating the premi-um. The majority view contends: “Return expectations arecoming down for all investment categories and any reductionfor real estate will be relative to stocks and bonds.” Others sug-gest that cap rates will increase with interest rates, “but won’t befully correlated on a one-for-one basis.”

A vocal interviewee minority argues that cyclical forces willcontinue to dominate real estate markets and recent pricing lev-els will deflate with higher rates. In fact, cap rates have notcompressed to such low levels since 1990 on the eve of the lastmarket bust. (See Exhibit 1-6.) “The whole relative-value argu-


0%

5%

10%

15%

20%

25%

‘04 2Q ‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84 ‘82 ‘80

Exhibit 1-4 “Prime” Lending Rate

Source: Federal Reserve Board.

–2.00

–0.75

0.50

1.75

3.00

4.25

5.50

‘04 2Q ‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84 ‘82 ‘80 ‘78 ‘76 ‘74 ‘72 ‘70

Exhibit 1-5 Spreads Between ACLI Cap Ratesand Ten-Year Treasuries

Sources: American Council of Life Insurers, Federal Reserve Board,PricewaterhouseCoopers, Economy.com.

Note: 2004 figures as of June 2004.

2.10 average (1970–2004)

Perc

enta

ge P

oint

Spr

ead

cannot paper over property-level shortfalls indefinitely.”

ment has been in vogue to rationalize the ‘disconnect’ betweenfundamentals and prices,” says a well-known investmentbanker. A leading research authority echoes: “Investors havebeen mistaking easy credit and low interest rates for structuralchange.” Clearly, 5 percent real estate cap rates on some apart-ments, downtown office buildings, and regional malls cannotbe sustained when ten-year T-bills price at competitive yields.“And that day could be approaching soon.”

The Economy: Modest GrowthLest we forget the last recession officially ended duringNovember 2001 (that’s right, two months after 9/11), realestate investors would be hard pressed to claim significant bene-fits from the ensuing recovery. Low interest rates and tax cutsmay have accelerated consumer spending and fueled homebuy-ing, but sputtering job growth generates insipid wage gains. Atsome point, real estate investors need burgeoning employmentrolls to fill office buildings, and greater take-home pay levels toencourage apartment renters and keep consumers spending inmalls. “The spark has been missing.”

A majority of Emerging Trends survey respondents anticipatethat the economy will gain momentum during 2005. Nearly 60percent predict medium economic expansion for the year, while30 percent anticipate at least low growth. Any warnings of anew recession barely register a blip on the surveys—some addi-tional measure of confidence. Still, only 10 percent of respon-dents suggest that dramatic growth is likely and a host of forces

signal “no clear sailing.” Interviewees cite rising concerns aboutfederal government budget deficits, balance of trade deficits, theweak dollar, unprecedented levels of consumer debt, inflation-ary pressures from uncomfortably high oil prices, risingemployer health care costs, choppy job growth prospects,queasiness over terrorist threats and the Iraq War, and increas-ing risks of interest rate spikes triggered by some combinationof all of the above. Some interviewees question “understated”inflationary impacts, given rising costs of energy products,health care, and commodities.

This stew of economic ambiguity again boils down to whathappens to interest rates and jobs. The large budget deficit andbalance of trade gap threaten to force upward pressure on inter-est rates. Increased government borrowing to close its deficitsgenerally forces up Treasury rates to compete for bond buyerinvestments. External trade deficits, meanwhile, weaken thedollar and increase demand by foreigners owning Treasuries tocompensate them for currency risk—that also translates eventu-ally into higher rates.

Back home, high gasoline pump prices gnaw away at dis-posable income and boost the cost of air travel. If turmoil inIraq and other corners of the Middle East continues to roil theenergy markets, winter home heating bills could shake con-sumer appetites. Consumers are already leveraged to the hilt oncredit card debt and home mortgages—“consumer debt is terri-


6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

‘04 2Q ‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84 ‘82 ‘80 ‘79

Exhibit 1-6 NCREIF Cap Rates

Sources: National Council of Real Estate Investment Fiduciaries,PricewaterhouseCoopers.

Note: Quarterly moving average.

Historical Average7.94%

–10

–5

0

5

10

15

20%GDP

Total NCREIF

‘04* ‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 1-7 Real Estate vs. Economy

Sources: U.S. Department of Commerce, Economy.com, National Councilof Real Estate Investment Fiduciaries.

*2004 GDP data are projected; 2004 NCREIF data are annualized for theyear ending in the 2nd quarter 2004.

0 1 2 3 4 5

fying.” “People aren’t afraid of debt anymore—they’ve beentreating leverage without regard to the downside, encouragedby all the cheap dollars.” If adjustable borrowing rates whipsawor advance more quickly than Americans can digest, consumerspending could be curtailed or even “choked off.” Homebuyingcould stall and the housing industry would be thrown for aloop. At the very least, any reduced consumer spending damp-ens economic growth prospects.

Interviewees acknowledge the intertwined vulnerabilities,but prefer to believe that the American “supertanker” economy“will grow our way out like we always do.” Don’t we “inevitablyrise to the occasion?”

Jobs QuandaryJobs, jobs, jobs—“Where will they come from, what types, andhow will they be housed?” In 2004, the economy finally startedproducing jobs in fits and starts, but incomes for most workers,adjusted for inflation, have been relatively stagnant and amajority of laid-off workers, working again, took pay cuts attheir new jobs. Most hiring concentrates at the lower end of theeconomic spectrum, which is dominated by restaurants, tempagencies, retail sales, and building services. The number of part-time workers also increased significantly. Discount store clerks,waiters, and “garage-guy consultants” don’t fill office buildingsor have the earning power to generate growth in other propertysectors. “The issue now isn’t so much job growth as the rightkind of job growth.” A consultant/academic anticipates “morezigs and zags in this economy than people would like to see.”

Many dominant American businesses—telecommunications,financial services, pharmaceuticals—have matured. Corporategiants in these industries merge and consolidate to squeeze outefficiencies rather than grow new jobs as in the past. An execu-tive suite focus on quarterly profits coupled with federal govern-ment belt tightening slows research and development spending.Halfhearted initiatives to send man to Mars or develop the next-generation fuel source so far gain little traction. Defense spendingpicks up significantly, but fighting Al Qaeda and Iraqi insurgentsrequires fewer big-ticket weapons systems than those needed dur-ing the Cold War. Although corporate profits have improved,cost-cutting efficiencies continue to play a greater role than newinitiatives. Interviewees look to health care and biotech to stimu-late growth, especially as baby boomers age. Advances in hightech should bring the industry out of its bubble-triggered slump.

“Businesses will need to upgrade after their extended round ofcost cutting, helping the tech sector,” says an interviewee. “Butthere doesn’t appear to be a silver bullet.”

Much of the 1990s’ high-tech–generated job boom, whichfilled office buildings and made rents skyrocket, turned out tobe more phantom than enduring. But productivity gains fromInternet, computer, satellite, and telecom applications have per-manently changed business practices in the office and industrialmarkets. Even with the proliferation of help-desk folks, the tech-nology revolution reduces per-capita office space requirements.


“Most interviewees express some discouragement over the slow pace of office market

Economic/Financial IssuesJob growth rates

Interest rate changes

Income and wage growth

Energy price changes

State and local budget problems

U.S. federal budget deficits

Asian economic growth

Offshoring and outsourcing

U.S. trade deficits

European economic growth

Social/Political IssuesTerrorism

Threat of terroism

Immigration

Iraq issues

Economic inequality

Real Estate/Development Issues

Land availability issues

NIMBYism

Home price inflation

Availability of affordable housing

Transportation funding

Smart growth

Environmental issues

Home price stagnation/deflation

Exhibit 1-8Importance of Various Trends/Issues/Problems for Real Estate Investmentand Development in 2005


1=no importance, 2=little importance, 3=moderately important, 4=largelyimportant, 5=very large importance.

Many companies no longer boast once-significant supportstaffs—BlackBerries, laptops, and voice mail reduce the need foradministrative assistants and receptionists. Workers spend moretime toiling on DSL-connected computers from home or hotels,and don’t require as much space when they show up at head-quarters. Taken a step further, companies can easily outsourcemore jobs to “consultants” and part-timers, who work fromrefitted basement or garage home offices and don’t receive costlybenefits. Controlling employee health care expenses—escalatingon average to upwards of $3,000 per worker annually—appearsto be a major factor extending the corporate hiring slump andkeeping some cubes empty.

Dare We Mention Offshoring?Of course, the ultimate technology-enabled productivity effi-ciency has been offshore outsourcing. Many interviewees con-tinue to dismiss the impact as “overblown media hype,” “a brat-ty issue that shouldn’t even be mentioned.” “What’s the bigdeal about tax returns prepared in India anyway?” A WestCoast developer proclaims “not a single tenant” in his portfoliohas been lost to offshoring. Other observers point to the offsetfrom new jobs created by foreign companies operating in theUnited States. But offshoring is really only an extension ofdomestic outsourcing and the ongoing transfer of workers toback offices by businesses that seek bottom-line improvementsfrom cheaper labor and cheaper space.

Companies are not picking up and relocating lock, stock,and barrel to India, China, and other offshore locations. That’swhy landlords can claim they have not lost any tenants to thetrend. But corporations steadily transfer some jobs overseasbecause of available well-educated workforces who get paid asmall fraction of American wage and benefit rates. A trickle ofanalyst jobs and accounting positions get ticketed offshore, andstart to multiply. The impacts quietly show up when companieslease less space or don’t expand to the degree they might havein a typical economic recovery.

Offshoring will not result in any mass exodus—that’s political-ly and practically untenable. Performance hiccups will occur andthe pool of qualified personnel in places like Hyderabad andBangalore may be more limited than advertised. “But it’s hard todeny that it is an issue,” says an office REIT executive. “Theeconomy is in transition, and offshoring is a moderator of growth.It is not as dismal as the alarmists predict, but it is part of the cur-rent lag and may be stalling some of the near-term acceleration.”

Increasingly, interviewees raise concerns about the nation’sschools and their ability to educate Americans to compete in arapidly evolving global economy that places a premium onmath and science skills—an area where U.S. students appear tobe falling behind. Web-based telecommunications systems haveeffectively broken down borders for companies seeking the besttalent at the lowest cost. “We need to do better if we are tomaintain our edge and keep creating high-level, high-payingjobs at home.”

Disappointing DemandMost interviewees express some discouragement over the slowpace of office market recovery. Vacancy rates hover in the highteens for suburban and mid-teens for downtown buildings.Rents have plummeted in many markets and new lease trans-actions will roll down net operating incomes from late 1990smarket highs even as rents recover. Tenant improvement pack-ages, higher local taxes, and inevitable capital costs depressreturns further. Smaller businesses take advantage of the ten-ants’ market and lead a budding leasing wave. Tenant reps saylarge companies finally are poised to follow, now that a surfeitof sublease space on their books has been retenanted and cor-porate profit outlooks improve. “Although the worst is over,”many observers extend the recuperation period into 2007 andeven 2008 for commodity office in fringe districts. “2005 is tooearly to expect much improvement.”

Apartment occupancies should start to advance once risinginterest rates dissipate the fervor of first-time homebuyers andemployment increases allow more echo boomers to leave homeor curtail “roommating” out of financial necessity. Demo-graphics point to a swell of young renters over the next decade,which should spur greater demand. Industrial vacancy rates,meanwhile, edge down off record highs in the low teens. Just-in-time technologies continue to make inroads, shifting marketdemand for industrial space away from storage capacity towarddistribution capability. Warehouse construction ramps up asbuyer zeal has pushed pricing well above replacement cost insome markets despite tenant softness. Again, recent investors inmultifamily and industrial properties count on greater econom-ic thrust to boost operating incomes. Their wagers on payingsuch low cap rates depend on it.


recovery.”

Hotel occupancies and revenues shoot up as companies feelgood enough about profit outlooks to increase executive traveland hold more meetings and conferences. At last, lodging own-ers start to feel “pricing power,” and room rate hikes fall rightto their bottom lines. With construction under control, hotelperformance—especially in full-service and upscale categories—could accelerate. A caveat: higher fuel costs may restrain car andair travel for both business and pleasure. Hotels also remain par-ticularly vulnerable to any new terrorism repercussions.

Retail has been the prime beneficiary among commercialproperty sectors of the recent low interest rate–induced mort-gage refinancing craze and federal tax cuts. With more moneyin their pockets, American consumers have headed to malls andpower centers in droves. Investors have followed suit. Somemoderation in shopping mania seems inevitable. Can con-sumers just keep spending and adding to record credit carddebt? We keep asking that question and at some point theanswer may be negative. Of course, a more vibrant economythat creates jobs could extend consumer cravings indefinitely.

Commercial DevelopmentCheckedVillains in the early 1990s real estate market debacle, commer-cial developers feel comfortable taking little responsibility forthe current oversupply in the office, apartment, and industrialmarkets. “This time round the vacancy problem has nothing todo with overbuilding.” Investors view the ongoing developmentrestraint with relief: “I’m less concerned about whether funda-mentals will improve,” says an insurance company lender.

“Banks have tamed the development cycle,” says aCalifornia developer. “Good institutional memory dating fromthe problems in the 1980s lingers. Very stringent underwritingfocuses on cash flow and debt service coverage, requiring signif-icant equity and preleasing. Their vigilance has cut down onspeculative building dramatically in this cycle.” In particular,mergers and consolidations among money center banks havereduced the availability of construction loans on major projects.“These big banks are more conservative.” Syndicating loansamong a smaller number of players has also led to greater disci-pline as well as checks and balances on construction lending.

“Capital is much smarter today and dictates the business,” saysa veteran Southwest developer.

Material shortages—China competes for steel supplies, lum-ber is earmarked for reconstruction efforts in Iraq—escalateconstruction costs. “We see double-digit increases.” Some con-tractors enter lotteries to purchase concrete for projects. Higherconstruction overheads raise replacement cost barriers and pro-vide justification for higher pricing on existing buildings. “Thatcould help keep upward pressure on values.” But commodityshortages and bigger development budgets could also sidelinesome projects.

Hardening antigrowth sentiment and environmental restric-tions also constrain the supply side in some regions. TheNIMBY syndrome impinges on developer options and delaysnew projects in expensive, drawn-out entitlement processes thatoften lead nowhere. Some interviewees champ in frustrationover the restrictions. “It’s just a huge problem that must beovercome.” Antidensity movements lead to the election of“antigrowth government officials” and “poor or impractical regula-tions.” The “one- and two-acre lot mentality” exacerbatesaffordable housing shortages and actually encourages sprawl.But others contend that “development regulation controlsgrowth, and favors better projects and better developers.”


“Growing numbers of empty nesters and echo boom singles seek housing closer to

0Abysmal

5Fair

10Outstanding

Real Estate Services

Homebuilding/ResidentialLand Development

Financing as a Lender

Investment

Commercial/MultifamilyDevelopment

Exhibit 1-9Real Estate Environment Prospectsin 2005


Housing SplurgeLow mortgage rates and federal subsidies, including downpay-ment grants, have pushed U.S. homeownership close to 70 per-cent, a record by any measure. Huge buyer demand has spurredhomebuilders and multifamily developers into constructionoverdrive—subdivisions, high-rise condominiums, infill andfringe projects spring out of the ground like weeds whereverbuilders can muster entitlements. Existing homeowners marvelat how rising property values over the past decade haveincreased their net wealth beyond any other “investment”—forget about the stock market. During the 2001–2003 periodalone, the median price of an existing home in the UnitedStates jumped 15 percent and prices are expected to increasenearly another 10 percent in 2004. Many people eagerly haverefinanced mortgages or taken out home equity loans on theirballooning equity, using proceeds to fund expansions, acquirenew cars, or just buy stuff at the mall. Affluent baby boomerssnag resort-area condominiums and second homes in prepara-tion for retirement. Young couples and 20-somethings put littleor no money down on starter homes thanks to aggressivelenders—payments on their adjustable-rate mortgages aren’tmuch more than apartment rents, at least for now. Viva homesweet home that I own—well, that is, along with my bank.

Now interest rates are slowly rising—adjustable-rate mort-gage payments will start to increase. In addition, property taxesin many communities have shot up as home prices have risenand local governments look to make up shortfalls from reducedstate aid and federal government programs. New “homelandsecurity” costs also have been drains. Property reassessments cap-ture recent value hikes and may result in whopper tax bills insome communities. All these payments come on top of carloans, credit card debt, and normal monthly bills that manyAmericans juggle as a matter of course. Oh yes, gasoline priceshave been a bear—those low-gas-mileage SUVs may not be sopractical after all—and heating bills this winter could be a back-breaker. Maybe renting that apartment would cost me a lot less!

Rising construction costs, meanwhile, begin to inflate newhome prices. Good tracts are more difficult to tie up. Localgovernments force homebuilders to pick up the tab for roads,schools, and sewers, all of which are becoming more costly toprovide. “The gravy train” days—when federal subsidies andgovernment highway grants paved the way for new home con-struction—have come to an end. “So far we have been able topass these costs onto buyers, because of demand,” says a home-builder CEO.

But how much steam can be left in the housing marketswith homeowner costs in an inflationary mode, led by highermortgage payments? Many indicators point to a market atcyclical peak—“It just can’t get any better.” At the very least,rising rates will knock some buyers out of the market. “Priceswill have to adjust as interest rates go up,” says a researcher.“The market has been overhyped. Some homeowners are over-leveraged and defaults are coming. It won’t be a bloodbath. Butit’s another sobering element.”

Optimists keep faith that interest rates will not ratchet up tooquickly and sustain the market. “Everybody has been spoiled by4 percent interest rates. Six-and-a-half percent won’t bring peopleto their knees.” But will upward rate adjustments stop there andhow fast will they move? That’s the worry. Any cooling of thehousing markets would affect the overall economy. Housing con-struction has been an important growth engine, generating con-struction jobs and supporting commodity pricing.

Shifting Lifestyles, ChangingDeveloper FocusDeveloper attitudes shift to accommodate emerging marketrealities. Mounting traffic congestion and a lack of mass trans-portation in many built-out suburbs focus attention on infilland mixed-use town center projects with pedestrian-friendlydesigns. “A lot of multifamily development is taking on theurban village concept,” says a developer in the Northwest.“With fewer fields to plow down, abominable traffic, and theland density issue, people want to live closer to work or transit.This will lead to more expensive, complex, and dense develop-ment” and favors larger-scale developers and homebuilders.

If energy prices stay high, shorter commuting distances andreduced errand time in the car will become more prized byrenters and homeowners looking to alleviate gas pump shock aswell as frustrating, gas-guzzling bumper-to-bumper delays.“People just want out of traffic.” Growing numbers of emptynesters and echo-boom singles, meanwhile, seek housing closer todowntowns and/or mass transit. They want proximity to 24-hourcenters and convenience to work, restaurants, cultural institu-tions, and recreational areas. Choice suburban school districts arenot a selling point for either of these expanding demographiccohorts. “Household growth is childless. Lifestyles are changing.”


downtowns and/or mass transit.”

Mass market developers gladly appropriate new urbanistconcepts—integrating parks, sidewalks, retail centers with apart-ments, townhouses, and single-family homes in pedestrian-friendly neighborhoods. Quaint retro-village developments of the1980s and early 1990s have become “a product of choice.” Smartgrowth influences are “no fad,” says the CEO of a major home-builder. “New urbanism has definitely been mainstreamed.”

Denser infill, village center developments will force home-owners to trade off size for convenience. Expect these projectsto concentrate in obsolescent urban industrial zones or inner-ring suburbs “where people will tolerate greater density” andwhere failing greyfield malls present opportunities for tear-downs and reuses. Some developers, lenders, investors, andlocal officials also focus on major urban mixed-use redevelop-ment, converting forlorn urban sites into residential and retailspace with offices and possibly hotels or even stadium/arenasincluded. “To have any chance of success there must be hous-ing.” Projects can be difficult to underwrite—their complexitylimits lenders’ interest. “One component always turns out to bea dog,” says an insurance company executive. Tax breaks andbond issues can help ease feasibility concerns.

Interviewees don’t expect Americans to give up on theirdreams of suburban “McMansions” and expansive backyardsdespite traffic snarls and growth restrictions. “There is smartgrowth and then there is real growth,” says a Dallas developer.“You may be able to control growth to certain cores or suburbs,but then places around them are going to do what they want todo—grow and sprawl. Nothing much you can do to stop it.Real growth is suburban sprawl.” He may be right, especially inmarkets without barriers to entry and land to burn to the hori-zon. But conditions wane for unremitting horizontal develop-ment in many areas, while imperatives and market demandintensify for denser, more integrally planned communities andprojects. Even at the edge, builders look to develop more mas-ter-planned, town center–styled communities that avoid thepitfalls of more one-dimensional, greenfield subdivisions.


“New urbanism has definitely been mainstreamed.”

0Abysmal

5Fair

10Outstanding

Areas Proximate to Transit Stations

Suburban Business Districts(pedestrian-oriented)

Planned Communities

Inner-Ring Suburbs

Central Business Districts

Suburban Interstate Highway Corridors

Resort Locations

Suburban Fringe Locations

Suburban Greyfields/Redevelopment Sites

Inner-City Locations

Suburban Strip Commercial Locations

Exurban Locations

Suburban Business Parks

Exhibit 1-10Prospects for Investing andDeveloping in Specific GeographicLocations in 2005


Note: Survey respondents were asked to choose one of four property typesand then rate the location based on that property type. Of the 290 respondentswho answered this question, 36.6 percent rated the locations for office, 24.8percent for apartments, 21.3 percent for single-family residential, and 17.2percent for retail. The overall rating presented here is an unweighted averagethat combines the ratings for each property type.

Global Uncertainty Shadows the MarketsThrough 2004, office buildings in Manhattan and Washington,D.C., traded at 5 percent cap rates and their vacancies were thelowest in the nation. Tourists poured into various attractionsincluding the reopened Statue of Liberty and the museumsaround the Capitol Mall. Together with southern California,these cities continue to rank as survey respondents’ favoriteinvestment markets. Obviously, the risk of terrorism has notinfluenced pricing or their standing as global centers. Eitherpost–9/11 concerns seem to have dissipated in a wave of com-placency or investors are more confident that any future terror-ist acts will have fleeting impacts on these world capitals, givenhow they have bounced back from the 2001 attacks. To somedegree, terrorism “has been factored out of the system as every-one goes about their business.”

A handful of major market corporate headquarters build-ings—particularly housing global financial giants—continue tofeature expensive security systems, including airportlike metaldetectors, photo identification scanners, elevator bank turn-stiles, and even X-ray screenings of packages and carrying cases.Wall Street is permanently blocked off around the New YorkStock Exchange like the White House on Pennsylvania Avenue.Most companies now have secure backup technology systems,and some larger corporations have decentralized operationsbeyond typical back office locations. Leading 24-hour citieshave strengthened building and fire safety codes, forcing land-lords to upgrade emergency evacuation systems and procedures.But in most markets, frugal corporate honchos and landlordsback off spending on building-related security upgrades theymight have considered after the 9/11 attacks. Investors, mean-while, expect the federal government to keep extending back-stops to insulate property insurance carriers from potential loss-es in terrorism coverage.

For all the business as usual, terrorism remains animmutable force and cloud on the real estate markets. “It per-vades the entire economy, creating uncertainty,” says an inter-viewee. “You can’t quantify it, you hear very little discussionabout it, but it’s there even if it isn’t factored into pricing.”

The repercussions from rooting out terrorist threats and theeconomic costs of the Iraq War cannot be calculated. Deficitissues and rising energy prices must be a drag. If turmoil in Iraqsubsides and concerns about oil supplies abate, then oddsimprove dramatically that the economy can get untracked.Even so, hotel owners worry about incidents that will shutdown air travel or discourage tourists. Shopping center execu-tives shudder over what would happen if a mall became a tar-get. On the margins, businesses are just more tentative. Whoknows if and when or even whether another jolt could happen?But the uncontrollable risk of a “bolt out of the blue” is consid-erably higher than it was before 9/11.

Given the state of real estate markets—the slow recovery toequilibrium and many highly leveraged owners—investorsprobably are more exposed to a dislocating geopolitical shock-wave than they would like to acknowledge. The short-lived liq-uidity crisis of 1998 taught everyone that real estate capitalmarkets are tied into global capital markets directly, and thathighly levered owners are susceptible to ugly meltdowns. Thepast ten years also offers lessons proving that U.S. real estatemarkets are particularly resilient and can rebound from jarringexternal surprises. Nobody is ready to venture a guess as towhat might happen “next time” as discomfiting insecurity shad-ows the markets.

2005 offers hope and opportunity, but little room forcomplacency.


Investment

“No bargains,but relative value.”

Leverage strategic-hold assets with fixed-rate debt whilefinancing rates stay attractive, and sell everything elsefor as long as the flood of acquisitive capital flows

allows. That’s the overwhelming investment advice of EmergingTrends interviewees for navigating the commercial real estatemarkets in 2005.

“Who knows what overpaying is in this market,” says aninterviewee, who “is selling everything in sight” and getting“ludicrous” prices. But “what looked highly priced three yearsago would be a bargain today, and some investors have givenup hope that prices will come down.” At some point, investorsstart overpaying and that line may have been crossed. “You can’tbe sure when it will happen, but buyers will revolt soon atsome of these prices, yields, and risk premiums.”

In fact, Emerging Trends surveys have never showcased awider spread between low-buy and high-sell sentiment or aslow a rating for buy opportunities. (See Exhibit 2-1.) “Thesmart money is selling,” says a national broker. “Our salespipeline is almost 50 percent above normal.”


c h a p t e r 2

Trends2005Emerging Trends Barometer: 2005

Buy Hold Sell

4.91

6.537.35

Buy/sell/hold rating prospects on a 0-to-10 (abysmal-to-outstanding) scale.

Exhibit 2-1


Note: 5=fair, 6=modestly good, 7=good.


Pay Up or Sit on the SidelinesThe problem then becomes where to reinvest the money. Someowners “cash in their chips” and wait for pricing risk to ebbdespite minimal returns from money market accounts or high-grade fixed-income investments. Real estate’s seeming “relativevalue” versus other investments still compels many players toplow capital back into properties. But some buyers lack convic-tion. “Prices may be very high, but the real returns for real estatestill look better,” says an interviewee. An investment bankeradds: “You can’t be an acquisitions guy without being optimisticand you’ll sit on the sidelines if you don’t meet the market.”

Much of the “frothy” purchasing has been justified by avail-ability of low-cost debt and spread investing. “Buyers lock inlong fixed-rate debt, net operating income just has to stay even,and they have a positive spread. In 20 years there can be threereal estate cycles. At worst they break even.” Buyers also “try torationalize” that higher construction costs have increased prop-erty replacement cost hurdles. “It makes them more comfort-able,” says a smiling broker, who revels in recent purchasers’frenzied bidding. “Don’t put a price on whatever you’re selling,or you’ll leave something on the table.”

At best, pricing offers “no bargains” and ignores the risk inmarket fundamentals, which just “don’t jibe.” Some buyers “arevisiting Vegas.” “What people are paying incorporates recoveryand more, leaving you tomorrow with a disappointing, verymediocre return,” says an interviewee. “You’ll probably get whatyou paid for and the income you can collect in between.” Inother words, investors may not court catastrophe with theiracquisition strategies, but they can forget about realizing muchappreciation.

Interviewees and survey respondents nevertheless forecastsustained capital flows in 2005 thanks to pent-up demand frominstitutional buyers, who will fill the vacuum left by privateinvestors and syndicators, if and when higher interest rates maketheir bread-and-butter leveraging strategies less desirable. (SeeChapter 3.) That means prices have a good chance to hold upduring the year, especially if tenant demand improves furtherand the Federal Reserve does not act precipitously. “It looks likeit will be more of the same—paying up to put money out.”

“For core fund managers, any new acquisitions probably will not enhance future

20042005

Exhibit 2-2 Total Expected Returns for U.S. RealEstate Investments in 2004 and 2005


Opportunistic Real Estate Investments

Value-Added Real Estate Investments

Core Real Estate Investments (leveraged)

CMBS (unrated)

Publicly Traded REITs and Operating Companies

Core Real Estate Investments (unleveraged)

CMBS-BBB-rated (lowest investment grade)

Commercial Mortgages (whole loans)

CMBS-AAA-rated (highest-rated)

15.06%

14.15%

12.91%

12.19%

11.18%

10.87%

9.91%

9.45%

8.37%

8.16%

8.34%

8.07%

7.60%

7.17%

6.77%

6.35%

5.52%

5.24%


Tempered Core ExpectationsAs property brokers enjoyed “a record year” in 2004, institutionalportfolio managers faced the quandary of investing impatient cap-ital in markets that offered limited future upside. “Finding dealshas been extremely frustrating.” Investors seek to avoid brokerauction sales, attempting instead to ferret out off-market transac-tions by tapping relationships with operating partners, local devel-opers, and management companies. In general, Emerging Trendssurvey respondents are expecting core returns in 2005 to be simi-lar to those of 2004 (see Exhibit 2-2), but many interviewees weresomewhat less optimistic.

For core fund managers, who have been delivering attractivelow-teens returns to investors, any new acquisitions probablywill not enhance future performance. Either they make nonac-cretive transactions on traditional well-leased core properties orstretch into riskier deals with higher leverage than fits typicalfund investment parameters. Any portfolio cash earns minisculemoney market rates, if not put to work immediately. As interestrates rise, the likelihood increases that recent strong core fundappreciation from cap rate compression may start to reverse.

Some investors take liberties with core acquisitions. “Thedefinition of core has changed because of all the liquidity inthe market,” says an interviewee. “Core used to mean 90 to100 percent leased properties with credit tenants in primemarkets. Now it can be 80 to 90 percent leased in more off-market locations.”

As a result, caution flags signal concern about near-term coreinvestments, which may “risk more chance for depreciation thanappreciation.” Plan sponsors can’t achieve “a return above actu-arial assumptions, especially after fees,” warns a pension consult-ant. As interest rates rise, “core looks less and less compelling.”

A major institutional manager admits: “We need to reduceclient expectations appropriately about the returns they [clients]will be getting.” The relative value argument, nevertheless, sug-gests existing core portfolios with good diversification among allthe property types can continue to deliver solid, competitiveyields. What’s wrong with fairly predictable mid- to high-single-digit returns when the stock market keeps giving up its gains?

Opportunity Stays OffshoreOpportunity fund managers continue to promise returns thatexceed 20 percent, but 80 percent or more of their investments“will be outside the United States.” Leveraged office acquisi-tions in Japan (“where the economy may be taking off ”) andnonperforming Asian debt top acquisition lists. “Anybody inthe United States with a high-return strategy will have a verytough time achieving performance.” The only way to have achance employs “a ton of leverage [85% or more]” and goes“off the charts with risk.”

Savvy managers sell out existing portfolios. “It’s harder andharder to put out money,” says an opportunity fund executive.“My domestic pipeline is scary—few if any office, hotel, orretail possibilities.”

Value-added investors, sandwiched somewhere betweencore and opportunity, shift from office and retail to “all kindsof housing-related investments, tapping the homeownershipwave as long as it lasts.” The mix includes condominium con-versions, ground-up condominium development, entitling landand reselling to homebuilders—just about everything but actualsingle-family development. Deal sizes get smaller and moreesoteric, including student housing, even assisted living andmedical offices.

“The only way to be successful is to seek relative valuethrough a robust deal flow,” says a value-added investor. “Youneed to have a network of local operating partners who can giveyou access to private transactions or you’ll go nowhere today.”In other words, it is slim pickings.

Smart money waits ambivalently for market turmoil, whichnobody really wants to see. “Our outlook might change if theeconomy just plods along, interest rates more than creep up, ora terrorist attack occurs,” says an investment banker. That’s whythey call them vultures.

performance.”

InvestmentSell Nonstrategic Assets into theCapital WaveRisk premiums may have lowered and real estate relative valuearguments may prove out, but prices still appear over the top.Too many pros “are scratching their heads” about the outsizedlevel of buyer zealousness. Take advantage while you can: risinginterest rates could end the bidding war frenzy. Maybe not in2005, but the lights could dim in 2006.

Hold Some PowderEconomic uncertainty is greater than people may want toadmit. The employment picture is a mixed bag. The Islamicworld from the Palestinian territories to Pakistan is a cauldron,potentially controlling the fate of energy prices. Iraq’s open soremay take a long time to heal. Deficits and trade imbalancescould speed the pace of rising interest rates. Sudden capital dis-location is not likely, but it is more possible. Taking advantage“will be where real money can be made.” Under any circum-stances, defaults will increase in 2005, probably within manage-able levels. But distressed debt opportunities present them-selves. Know those CMBS special servicers.

Refinance at Low Fixed RatesSecure long-term fixed-rate debt on well-leased core assets now,before interest rates rise any higher. Low mortgage rates still offerthe chance to make hay out of spread investing “and you will getthrough the cycle without any problems.” Move quickly—itlooks like the window is closing. “Lock in rates as soon as possi-ble, period, exclamation point!”

Consider Buying in Former High-Tech HotbedsPainful tech industry consolidation appears mostly over,although software companies struggle to reinvigorate andexpand, and chip companies disappoint. Economists predictthat American business will need to step up tech spending to

remain competitive. Everyone waits for announcement of “thenewest, new, new thing,” but nobody bets on a 1990s-styleresurgence. “Tech may make a comeback, but it won’t be ofY2K-esque dimensions.” Among the obvious market beneficiar-ies would be Austin, the Boston 128 corridor, Denver, Seattle,and of course Silicon Valley.

Why Not Vulture Lending?Identify mezzanine lending opportunities to obtain preferredequity positions from potentially overleveraged borrowers. Onlythe most adept investors should play, but this off-market strate-gy can certainly avoid brokered bidding wars.


“Risk premiums may have lowered and real estate relative value arguments may prove out,

Best Bets 2005

DevelopmentDevelop Resort/Second Homes for Baby BoomersThe bulging demographic age cohort looks to retirementoptions now that children have left the nest. At peak earningyears with more disposable income, this graying tide focuses onwaterfront condominiums, mountain resort communities, andrelaxing getaway hideaways “to enjoy and use.” “No betterniche” exists “than the moderate/high-end resort vacationhome business.” Best locations include small college towns inthe temperate Southeast and anywhere just outside a two-hourdrive in a ring around the major metropolitan areas. “It’sdumbfounding what’s popping up in the middle of nowherelike Idaho and Montana.” Waterfronts along the Great Lakesstrike million-dollar homes. Folks from Chicago and Detroitbid up prices. Naturally warm-weather Florida and Arizona areprime retirement targets. State capital/university towns may be“the perfect storm,” offering sophisticated academic communi-ties with a wide range of cultural and entertainment activitiesfor spry seniors who don’t think of themselves as over the hill.

Develop 24-Hour Market Infill ResidentialEmpty nesters and later-marrying echo boomers move backinto 24-hour market centers. These growing childless demo-graphic cohorts prefer the stimulation and accessibility of citycenter attractions—restaurants, cultural institutions, nightlife,and workplaces. Traffic tempers the desirability of suburbanlifestyles unless you are raising families and covet good schooldistricts. Baby boomers look to trade in big homes and gardensfor a pied-à-terre in the city and a second resort home—“thebest of both worlds.” Infill housing meets growing demand.Anything near mass transit stops almost can’t miss—conven-ience counts. Securing precious sites for development is anothersafe bet. Buy land, obtain entitlements, and flip to residentialdevelopers. Prospects should only gain momentum over the

next decade as boomers and their children swell into thedemand curve. Caveat: overbuilding tempers some markets—like Chicago, which bolted ahead of growth prospects.

Develop Housing for Active SeniorsInvestors salivate over aging baby boomer demographics andfigure senior projects can’t miss. A premature investment wavein the mid-1990s hit the skids. Active senior communities—age-restricted townhouses/apartment/villa developments—havebegun to gain traction. These projects satisfy graying suburban-ites who want easier lifestyles but resist move-back-in trends.But don’t bury baby boomers yet in higher-care, assisted livingfacilities. The oldest boomers are barely 60 and their averagelife expectancy exceeds 80. They focus on golf and fishing, noton rocking chairs and elder care.

Cautiously Pursue Urban Mixed-Use ProjectsThese developments require strong retail and large residentialcomponents to ensure success. Though they are difficult to pulloff, revived districts that can offer “a strong sense of place”experience increased market demand. This category rankshighest for investment prospects in the Emerging Trends surveyamong specialty property types. Denver’s LoDo, San Diego’sGaslight Historic District, Portland’s Pearl District, andArlington, Virginia’s Market Common, Clarendon provideblueprints for creating exciting 24-hour environments thatrestore urban vibrancy. Developers, lenders, and investors needto work closely with local governments, businesses, and commu-nity groups to determine the right local formulas. These vision-ary projects can change the fortunes of neighborhoods andentire cities. Suburban town centers—Reston (Virginia) TownCenter, Southlake Town Square (outside Dallas), KierlandCommons (Phoenix), Birkdale Village (Charlotte)—also winkudos from shoppers, homebuyers, and tenants who appreciatethe pedestrian-friendly environment and convenient amenities.


but prices still appear over the top.”

Look at Niche DevelopmentThe generation Y cohort heads to college in growing numbers,spurring demand for student housing. Some affluent boomerparents invest in nearby campus condominiums to give theirkids greater creature comforts. Demand for tax credit affordablehousing remains unquenchable.

Yellow-Flag Some Condominiums,Starter HomesHigh-end infill condominiums in prime 24-hour markets likeNew York and Washington, D.C., and in southern Californiashould do fine. The same can be said of many resort area proj-ects. Beware of areas where buying is dominated by speculators,including some Florida markets. Condominium developmenttailored to first-time homebuyers in low-barrier-to-entry mar-kets could slam into rising interest rates. Commodity single-family home development where houses have been selling withlittle money down and adjustable-rate debt could suffer thesame fate. Defaults will start to increase. Time to cool it!

Property SectorsHold Moderate-Income ApartmentsPricing has been rich, probably at replacement cost. But tenantdemand should firm up as rising interest rates deter first-timehomebuyers. Any anticipated employment growth and wagegains will encourage more people “to look for their own places”and move away from parents or roommates. Increasing demandwill push rents. More echo boomers entering the workforceover the next five to ten years will create additional momen-tum. Urban coastal markets offer excellent prospects. SouthernCalifornia rates best.

Secure Tracts for WarehouseDevelopment Vacancies stubbornly lurk near record highs in some markets,but institutional buyers bid up pricing well above replacementcost on existing big-box industrial properties, and developerssee opportunity: “It’s cheaper to lease up new projects.” Just-in-time logistics continue to threaten aging warehouse storagespace with obsolescence. An improving economy should liftdemand further for newer, more desirable space. Higher-ceilingdistribution industrials in hub transportation markets satisfycore investors’ appetites for solid income returns.


“If you want fortress regional malls, better buy REIT shares.”

Buy or Hold Full-Service Hotels“We’re on the cusp of a significant ramp up of average dailyroom rates.” Development has been significantly curtailed androad-warrior travel is increasing. Meeting and conference busi-ness has finally returned. Focus on gateway cities and moreupscale properties. “It’s the right time in the cycle.” But buyerswill have plenty of company. Forget about steals. In the currentseller’s market, acquisition opportunities are all relative.

Be Careful about Retail“Totally overplayed.” From a pricing standpoint, “it’s thebiggest risk.” Paying up for neighborhood malls is “playing theslots.” Investors buy yield, but the “Wal-Mart effect is a hugerisk.” If you want fortress regional malls, better buy REITshares. Despite recent value gains, long-term prospects for Band C malls have not improved—many are threatened by theproliferation of power and lifestyle centers. The competitionforces uncomfortably high capex (capital expenditures) risk.Redevelopment of some flagging malls into power centers orother uses will continue.

Steer Clear of Commodity OfficeTypically at this point in the cycle it’s time to buy B-qualityvanilla office and ride economic recovery to strong occupanciesand rent spikes. In three to five years you flip. Concerned inter-viewees claim rollover risk is too great in the current market, andrents will trend down from late-1990s highs before they pushback up. “Replacement tenants will be hard to find.” “Avoid likethe plague” and forget about development opportunities.


Real EstateCapital

Real EstateCapital

“I don't think

there can be more

liquidity.”


c h a p t e r 3

FlowsExhibit 3-1 Real Estate Capital Market Balance

Forecast for 2005


1.04% Substantially Undersupplied5.18% Moderately Undersupplied

9.07% In Balance

42.23% Substantially Oversupplied

42.49% Moderately Oversupplied

0.52% Substantially Undersupplied4.64% Moderately Undersupplied

20.36% In Balance

26.29% Substantially Oversupplied

48.20% Moderately Oversupplied

Equity

Debt

Typically in past real estate cycles, one outlier groupwould pump up markets in often overly enthusiasticbuying sprees. During the early 1980s, tax-shelter syn-

dicators got into trouble, followed later in the decade by thetrophy-office-hunting Japanese. Wall Street opportunity fundsled the industry out of the early 1990s depression. Then surg-ing REITs became “accretive buyers” before their high-growthstory hit the wall. Germans took over for a short period, bid-ding up office building prices in gateway markets. “Now it’severyone into the pool,” including high-net-worth syndicates,private REIT investors, 1031 exchange buyers, tenants-in-common, pension funds, and even a slew of Australians.Together they have precipitated “an extraordinary period ofinvestor demand,” facilitated by low interest rates. Both debt andequity capital markets are moderately to substantially oversuppliedwith capital, according to survey respondents. (See Exhibit 3-1.)

“The ‘big momentum’ has been too enticing,” says aninvestment bank portfolio manager. “Don’t fight it, join it.”Capital has not been totally irrational, given cap rate spreads,relative value comparisons to stocks and bonds, and the oppor-tunity for economic growth to increase tenant demand andrents. Still, borrowers have “gorged on cheap dollars” to buyand refinance properties, “maxing out on leverage.” People have


wagered that leasing will improve quickly, “but they are bettingwith someone else’s money.”

Even as interest rates head north, “a ton of capital” waits fora home—or, well, an investment property. Syndicators continueto attract buckets of money from individual investors fed upwith the stock market. Financial planners, wire houses, broker/dealers, and investment banks, among others, have enticed tensof billions of hungry retail dollars by marketing real estate as asteady, income-generating “safe harbor.” Investors have notbeen deterred by generous front-end loads, which swell brokerprofits but may compromise eventual returns.

“Even as interest rates head north, ‘a ton of capital’ waits for a home.”

Pension funds, meanwhile, have been raising real estate allo-cation targets, because of recent solid performance and theirgrowing need for predictable yields to pay the burgeoning num-bers of retirees in their plans. After watching prices advance andmissing out on the action, many plan sponsors now are con-vinced that “pricing is not an anomaly” and have reentered themarkets at full throttle. Offshore players—Germans and Aussiesespecially—remain a force to be reckoned with.

In 2005, survey respondents predict that capital availabilityfrom both debt and equity sources will fall only slightly fromunprecedented 2004 levels. (See Exhibit 3-2.) Pension fundswill lead the equity investment charge as interest rate hikesbegin to slacken private capital momentum. “Tremendousamounts of institutional capital have been committed in reallo-cations, but have not been invested,” says an investment bankresearch head. “Major funds have large queues of dollars wait-ing to be funded and are hungry to see it invested.” At thesame time, CMBS issuers and banks will remain ready financ-ing sources. Even interviewees with qualms about unrealisticcap rate assumptions expect “the investment pattern to contin-ue through 2005, given the lack of alternatives.”

Lending activity should remain robust in 2005, led by theone-two punch of CMBS issuers and banks. About 50 percentof survey respondents anticipate lending underwriting standardswill remain the same in 2005, and about 37 percent of respon-dents believe they will become more stringent. (See Exhibit 3-3.)Opinion is mixed over lending restraint or the lack of it. “TheRosetta Stone for markets has been the discipline of construc-tion lenders,” says an interviewee. “Very few markets are out ofcontrol.” The competitive environment, however, has forced uploan-to-value ratios and pushed down debt service coverage.“Some lenders have been dumb, taking no amortization and no

0Abysmal

5Fair

10Outstanding

20052004

Exhibit 3-2 Availability of Capital for Real Estatein 2004 and 2005


All Sources

Pension Funds

Opportunity Funds

Entrepreneurial Capital

Foreign Investors

REITs

All Sources

CMBS Sector

Major National Banks

Local/Regional Banks

Insurance Companies

Savings Institutions

Equity Capital

Debt Capital

Exhibit 3-3 Underwriting Standards Forecast

36.76% More Stringent

Predicted Change in Stringency of Underwriting Standards forCommercial/Multifamily Mortgages in 2005

49.61% The Same 13.62% Less Stringent



reserves,” said an insurance company honcho. A banker countersthat lenders have been aggressive on spreads, but not loanamounts, and seem well protected on holdbacks and escrows.“It’s hard to get in trouble thanks to low interest rates.”

“First mortgage positions appear very safe,” says a CMBSinvestor. “There is no longer a binary relationship between thefirst lender position and the overall mortgage investment.Securitization spreads risk to investors who have sliced anddiced risk into tranches of mezzanine, B-piece, and unratedpositions for higher returns.” But these finance layers also candistort and dilute transaction risk for the higher-risk positions.“Slicing and dicing clouds protection in the layering,” says aninsurance executive. “Complexity may add to the risk depend-ing upon where you are in the stacking plan. So far, there hasn’tbeen a real test of what happens if it unravels.” Most investorsin higher-risk tranches have been well rewarded for their invest-ments. Defaults have been “negligible.” Problems in limited-service hotels and assisted living subside, replaced by smallpockets of multifamily distress. “Overall, it’s under control.”

Capital Trends: Equity PlayersPrivate Investors and SyndicatorsFor the past three years, institutional investors have lambastedsyndicators and some private high-net-worth investors forinflating the markets and making stupid, highly leveraged deals.In the meantime, they watched flat footed as prices kept risingand private investors started hitting doubles, triples, and evensome home runs in roundtrip transactions. “The nontradedsector has performed well,” claims a private REIT syndicator.“A rising tide has lifted all boats. This is not the tax-driven syn-dication business of the 1980s. It’s market and economy drivenwith conservative strategies, looking for mid- to upper-single-digit returns in undervalued, well-leased properties.”

But bilious outrage over the hodgepodge of private playerscontinues to pour out of interviewees as money keeps flowinginto the markets to buttress everyone’s portfolio returns. “1031exchange investors have driven up prices 5 to 10 percent all bythemselves.” “It’s never good when you see doctor syndica-tions—that’s a huge red flag.” “It’s dumb money.” “People are

buying anything” and “floating-rate leverage is rampant.”Broker dealers chase fees “in a pig fest.” Fifteen percent front-end loads “set investors up for failure and sink returns.” “It’s theclassic failed business model.” “A lot of people may end upspooked.” “It’s disgusting.”

In fact, private buyer syndicates, who had been targetingsmaller acquisitions, mostly apartments, in the $10 million to $20million range, more recently have been involved in major down-town office purchases at some headshaking prices with heavyfinancing doses. “They have been driving the markets, no ques-tion.” Many interviewees continue to predict that private REITswill produce “disappointing” performance—returning principaland income less fees but without much hope of appreciation.

Over the long term, that might not be good enough to holdthese more fickle relative value investors. Consensus reigns thathigher interest rates will curtail private sector investments in2005. But unless the stock market catches sustained fire or realestate returns nosedive suddenly, this noninstitutional capitalcould have some staying power. Interviewees, who stake theiroptimism to enduring cap rate compression and ample capitalmarket liquidity, should hope so.

–5

–4

–3

–2

–1

0

1

2

3

4RetailOfficeIndustrialApartment

Priv

ate

Nat

iona

l

Priv

ate

Loca

l

Use

r/O

ther

REI

Ts

Fore

ign

Inst

itutio

nal

Exhibit 3-4 Net Capital Flows by Source andProperty Sector

Source: Real Capital Analytics.

Note: Annual net capital flows for the period mid-2003 through mid-2004.

($ B

illion

s)


“If and when private investor capital backs off, interviewees expect pension funds

Capital Sources and Flows

0

50

100

150

200

250

300

Foreign Investors

Life Insurance Companies

Savings Associations

Commercial Banks

REITs

Pension Funds

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90‘89‘88

0

200

400

600

800

1,000

Other

Federally Funded Mortgage Pools

Nongovernment CMBS and ABS Issuers

Foreign Investors

Life Insurance Companies

Savings Associations

Commercial Banks

REITs

Pension Funds

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90‘89‘88

Equi

ty($

Billi

ons)

Debt

($ B

illion

s)

Exhibit 3-5 Real Estate Capital Flows

Sources: Money Market Directory, NAREIT, FDIC, ACLI, BEA, Federal Reserve, Rosen Consulting Group.


to pick up much of the slack.”

REITs$252.2 Billion–52.62%

Pension Funds$145.0 Billion–30.24%

Savings Associations$173.0 Billion–8.18%

Foreign Investors$214.8 Billion–10.16%

Life Insurance Companies$242.4 Billion–11.47%

Nongovernment CMBS Issuers$372.6 Billion–17.63%

Federally Funded Mortgage Pools$114.7 Billion–5.43%

Other$59.1 Billion–2.80%

Pension Funds$33.6 Billion–1.59%

REITs$10.4 Billion–0.49%

Commercial Banks$893.4 Billion–42.26%

Institutional: $2,593.34 Billion

Noninstitutional: $2,804.05 Billion

Total U.S. Real Estate: $5,397.39 Billion

Sources: Money Market Directory, NAREIT, FDIC, ACLI, BEA, Federal Reserve,Rosen Consulting Group.

Savings Associations$0.8 Billion–0.17%

Commercial Banks$2.4 Billion–0.5%

Life Insurance Companies$30.2 Billion–6.31%

Foreign Investors$48.7 Billion–10.16%

InstitutionalTotal Equity: $479.3 Billion

InstitutionalTotal Debt: $2,114.0 Billion

Exhibit 3-6 Institutional Capital Sources

Pension Funds If and when private investor capital backs off, intervieweesexpect pension funds to pick up much of the slack. “The pri-vate guys have had their run. Institutions will take over in2005.” Pension funds seem always late to the party, and charac-teristically these more conservative investors have not led thecharge during the recent buying splurge. Larger plan sponsors,including state employee funds with established real estate port-folios, have generally played the market strategically, sellingassets into the capital wave and avoiding bidding contests onacquisitions. Typically spurning high-leverage investment struc-tures, they cannot compete against many syndicators who usefinancing with abandon. “We’ve been bidding, but losing dealafter deal,” said a public fund executive. Consequently, manypension property portfolios have contracted just as many plansponsors raised allocation targets to achieve increased yields andmeet cash demands from an earnings gap versus their requiredretiree payouts. “Show me stable returns that offer diversifica-tion to other investments and I want it,” says a state pensionfund administrator. “Pension funds want to diversify away from

the equity beta and have less dependence on appreciation.That’s why they like real estate.”

Smaller plan sponsors, endowments, and foundations havecaught the real estate bug, too, after many steered clear in thewake of the early 1990s market debacle. Strong cyclical per-formance and income-driven returns are too attractive to passup now. “Pension funds need to diversify portfolios,” says aleading consultant. “Market timing is not the issue. The key isto get their allocations out prudently.” Consultants recommendthat funds step up portfolio target allocations to 5 to 10 per-cent of total assets. “Anything less is not beneficial.” Currently,the total pension universe invests less than 5 percent of assets inreal estate. Some plan sponsors invest up to 15 percent, whilesome smaller plans continue to avoid property investments.

“The pressure is on to make acquisitions” and investmentmanagers are caught in an uncomfortable squeeze. “It’s beeneasy to sell, but hard to recapitalize and improve portfolio risk.”The challenge for most advisers is “to withstand the pressureand weigh the client patience level.” But managers also haveincentives to place money and earn asset management fees, andsome pension funds are “forcing capital out.”

Certain funds also increase leverage limits, even though itslows investment in equity. At least they take advantage ofspreads and can compete to invest some money. Once leverageis no longer accretive, “they are sure to back off.” To gain betteraccess to transactions, pension investors joint venture withREITs and other operating partners, who demand leverage ontransactions. “They won’t do deals otherwise.” Other funds,frustrated by the slow pace of real estate equity placements,invest directly in REIT stocks. “It all looks like the wrongtime,” says an investment manager. “They’re buying when pric-ing is well above historic ranges and net asset values, driven bya need for current income.” For those plan sponsors just gettinginto the game, “they may be disappointed.”

Sponsors, consultants, and investment managers hope thatonce higher lending rates curb private investor enthusiasm, theacquisition market’s exuberance will recede enough to allow formore comfortable pricing. Nobody expects any bargains, butmaybe they can make deals that will produce returns abovetheir actuarial assumptions. A public fund executive muses:“Can you imagine the impact on pricing if all funds put outtheir money at once to meet their new allocation targets?” Nowonder interviewees retain confidence that capital flows willhold up in 2005.


“REITs continue to solidify their market leading position and clearly dominate the instituti

$0B

$1,000B

$2,000B

$3,000B

$4,000B

$5,000B

$6,000B

$7,000B

$8,000B

Total Pension Fund Assets (left scale)

0%

1%

2%

3%

4%

5%Percentage of Pension Fund Assets in Equity Real Estate (right scale)

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90‘89‘88

Exhibit 3-7 Pension Fund Assets in Equity Real Estate

Sources: Money Market Directory, Rosen Consulting Group.

Real Estate Investment TrustsDespite the surge of private investment and newfound pensionfund assertiveness, REITs continue to solidify their marketleading position and clearly dominate the institutional capitalmarkets with a 53 percent equity share compared with only 30percent for pension funds. (See Exhibit 3-6.) The REIT growthtrack has been steady and impressive, building from less than$15 billion in total market capitalization in 1992 to more than$250 billion in 2004. Just five years ago, pensions commandeda 39 percent institutional market share versus 38 percent forREITs. Capital inundates REIT mutual funds and stocks fromsmaller institutions and individual investors, who cannot accessthe private markets easily and like the strong dividends.

“REITs have become the gathering place for mature assets,while development and growth strategies will take place moreon the private side,” says an investment banker. Indeed, manyREITs, established in the early 1990s by cash-strapped entrepre-neurs as a strategy to escape foreclosures in illiquid capital mar-kets, have become “cycle-tested” institutional-scale enterprisesoperated by highly skilled corporate-styled management teamswithout developer zeal or risk-taking fervor. “Founders havegiven way to professionals.” A REIT CEO asserts: “We shouldnot be looked at like a collection of assets, we’re a company andwe are managed to maximize earnings across all our operations.”

Many companies stand “at a transition point, figuring out anew business model” that ensures they can maintain the solid,steady dividends that shareholders demand and expect. “We’relong past the stage when we will be recognized as growthstocks,” says a REIT honcho. “We’re moving away from justbuy and hold to more of a capital allocation model—buy, assetmanage, enhance, sell, and reallocate,” while trying to retainincome-producing management contracts. REITs entertainmore partnerships with pension funds and offshore capital,which have lower-cost capital. They can add to holdings andcritical mass, while enhancing operating revenues from fees.Companies have also boosted earnings by adding leverage whilemortgage rates stay low.

Some executives continue to chafe under REIT require-ments to pay out 90 percent of earnings as dividends, short-circuiting capital-intensive, higher-growth strategies like devel-opment. But moves to less passive structures like C-corps havebeen sporadic. Expected consolidation continues slowly as com-panies seek economy of scale advantages in corporate overheadsand from market share gains. Large mall REITs continue togain significant leverage over national retail chains in negotiat-ing tenant agreements. Apartment and office REITs look toconcentrate activities in specific local markets to improve mar-keting to tenants across regional holdings and centralize opera-tions as much as possible.

Returns will reflect the economy—“slow and steady.”Interviewees and survey respondents forecast that the publicmarkets will underperform private real estate in 2005, pointingto stocks’ outperformance in recent years and market prices inexcess of net asset values. “REIT upside is missing from earn-ings growth in real estate fundamentals,” says an interviewee.“The game of refinancing debt to create better income cashflow is ending. There is more downside potential in prices thanupside.” Rising interest rates will also pressure companies tomaintain or increase dividends and hamper them in the trans-action markets, where private investors can still use leverageand accept lower initial yields.

Shareholders and stock analysts tend to lump companiesinto property sector groups, especially malls, which tradetogether “in tight bands.” “Little differentiation between realestate stocks exists among investors.” Interviewees continue todebate whether REITs are a private real estate proxy, a comple-ment, or volatile dividend-producing stocks. Over long-terminvestment horizons, REITs and private real estate provide simi-


ional capital markets.”

–20%

–10%

0%

10%

20%

30%

40% NAREIT

NCREIF

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92

Exhibit 3-8 Equity Real Estate Performance vs. REITs

Sources: National Council of Real Estate Investment Fiduciaries (NCREIF)and National Association of Real Estate Investment Trusts (NAREIT).

Note: NCREIF 2004 data are annualized from first two quarters. NAREIT 2004 figure is annual return from second-quarter 2003 throughsecond-quarter 2004.

lar returns, but REIT performance is considerably less stableand increasingly tracks the overall stock market. “Volatility isreduced in private markets, because investments are not markedto market. In the end there is not a huge distortion.” But apension executive complains that “REITs are too susceptible tocapital flows and the vagaries of the capital markets, whichdon’t bear on real estate attributes. Eventually, REIT holderswill be disappointed with volatility.”

Investors are learning to tier REITs by sector, geography,and strategy, which is more difficult to accomplish on the pri-vate side, says a REIT executive. “Availability and interest ininternational REIT stocks are also increasing.” “It’s certainly thebest way for the general public and smaller institutions toaccess real estate markets.”

Foreign InvestorsSteady flows of offshore money keep “backbone” in the capitalmarkets. Foreign investors “have been consistently in the hunt”for acquisitions, bidding actively alongside the rabble of other pri-vate and institutional sources. Everybody gravitates to stable U.S.markets and the weak U.S. dollar can enhance buying power.

“Very aggressive” German players may “take a breather,”given record-low cap rates for the core, stabilized assets on theirshopping lists. Afraid of cap rates decompressing, Germans

“will buy only the safest of the safe to weather the next fiveyears as interest rates go up.” Closed-end syndications, similarto U.S. private REITs, “cannot find competitive yields” inoffice and retail acquisitions given high pricing. They avoidmultifamily—“Germans are unfamiliar with garden apartmentssince they don’t exist in Germany.” German open-end fundsalso find tough sledding in familiar overheated top-tier officemarkets where they concentrate activity. “D.C. has been thefavorite,” but it is now too expensive.

Dutch investors continue to invest in U.S. REITs or operat-ing companies, but shy away from direct investments. In gener-al, rising familiarity overseas with REIT structures has madeforeign investors more comfortable with investing in U.S.REITs. French and U.K. investors seem to stick to home cook-ing. “They don’t crop up among competitors.”

Australians now rank as the most active foreign investors afterthe Germans. Government pension diversification mandates and adearth of domestic property options coax Aussie superannuationfunds and trusts to American shores. Hungry for yield, Australianfunds find “slightly” higher returns in U.S. holdings than in theirdomestic assets. Higher interest rates and sky-high pricing inAustralia make the United States look very competitive.

Asian money from Singapore, Malaysia, and Indonesiaremains regionally focused. But Japanese capital may be edgingback into U.S. real estate markets after a 15-year hiatus. “TheJapanese are looking for stable dividends, a new tax treaty willbe advantageous, and their economy is improving after a longdecline. The arithmetic is finally working again.” Expect “lowkey” investing rather than the “flashy,” price-is-no-object pur-chases made in the 1980s. Back then, high-profile acquisitionsof countless downtown trophy landmarks and even the PebbleBeach golf resort ended in big losses when markets tanked. SomeJapanese will dip their toes in 2005, “starting with REITs.”

Arabs and Israelis cannot agree about much, but bothgroups remain active in U.S. property markets, looking for asafe haven from their regional conflict.

Wall StreetInvestment bankers’ attention shifts overseas as opportunityinvesting dries up in the United States. They remain vigilant incase domestic market distress develops. Major financial compa-nies move to expand private core fund offerings beyond pensionplans to high-net-worth, offshore, and individual investors. Realestate mutual funds and 401K options make further inroads.


“Very aggressive German players may take a breather.”

Exhibit 3-9 Foreign Investment in U.S. Real Estate

Sources: Survey of Current Business, U.S. Department of Commerce,Bureau of Economic Analysis, Rosen Consulting Group.

as of December 31, 2003

Germany11.9%

Africa and the Middle East 3.0% Asia except Japan 2.2%

Other Europe12.7%

United Kingdom9.8%

Australia7.0%

Netherlands9.7%

Canada 9.7%

Japan23.4%

Latin America 10.5%

Life InsurersYou have heard it before—the trend continues away from directreal estate ownership. There appears to be no turning back.

Capital Trends: Debt PlayersBanks and Insurance CompaniesThe liquidity in the system has made maintaining lending dis-cipline difficult as loan-to-value ratios drift up and debt servicecoverage ratios edge down. The interviewees’ overall view con-firms that banks and insurance companies have been generallyresponsible underwriters, competitive on rates, but generallyholding the line on loan amounts and terms with slippage atthe margins. “Underwriting has been appropriate and conserva-tive,” says an investment manager. No warning lights flashabout widespread delinquencies, let alone out-of-control fore-closures. The culture seems intact for avoiding major errors.The low-interest-rate environment has enabled borrowers tokeep paying down loans, despite less than vigorous propertycash flows. An unexpected interest rate spike would put a wholenew complexion on the market.

If banks don’t extend enough proceeds, borrowers haveadditional resources to access: some CMBS issuers will stretchmore on loan amounts and extend interest-free terms for a cou-ple of years. Mezzanine lenders will offer additional capital for ahigher rate of return.

Construction lending remains checked. All the availablemarket vacancy data chill activity, while bank regulators andstock analysts monitor trends closely. Any jump in developmentlending by major bank companies would draw unwelcomeattention from shareholders. Institutional memories run deep—no one wants a repeat of the early 1990s, when some bankswere brought to their knees by problem loans and the savingsand loan industry almost went belly up.

By 2007, higher capital reserve requirements loom for majorU.S. money center banks active internationally. The Basel IIaccord, an international framework for lenders, could increasethese banks’ cost of owning CMBS as well as making certainacquisition, development, and construction loans. Critics worrythat capital flows will be constrained if the draft regulationstake effect. The Swiss-based committee working on the finalaccord continues to weigh criticisms, including issues raised byCongress, which will need to adopt the regulations for U.S.financial institutions. Everyone should stay tuned.

The market clout of life insurance companies diminishes.They “try to be competitive as a preferred debt source,” focus-ing on first mortgages investing in higher-quality core CBDoffice, retail, and apartments. Borrowers may take less on loanamounts, but gain extra flexibility in refinancing or changingterms later.

Insurers’ CMBS comfort level grows—both for convertingportfolio loans into securitization pools as well as direct invest-ment. “We are out of private real estate and into real estatepaper,” said a life company portfolio manager. “Interest inCMBS and REITs has increased considerably across the indus-try.” In some cases, once-large insurer real estate departmentsshrink to a handful of managers, who oversee outsourced opera-tions, whole loan portfolios, and securities accounts.

Insurance foreclosures and delinquencies register barely ablip. “They’ve been on the best behavior in the history of lend-ing,” says an interviewee. Others question the industry data,but recognize that insurers have been careful. “CMBS has theriskier stuff.”


0%

2%

4%

6%

8%

10%

In-Foreclosure Rates

Delinquency Rates

‘03 ‘02 ‘01 ‘00 ‘99 ‘98 ‘97 ‘96 ‘95 ‘94 ‘93 ‘92 ‘91 ‘90 ‘89 ‘88

Exhibit 3-10 Life Insurance Company Delinquencyand In-Foreclosure Rates

Source: American Council of Life Insurers.

Commercial Mortgage-BackedSecuritiesCMBS popularity increases steadily, and conduit lenders gainmarket share over other lenders, increasing origination volumesthat translate into $1.5 billion plus weekly new issuance. In addi-tion, more than $1 billion a week in secondary market activityoffers “incredible liquidity” to investors. The number of B-piecebuyers also has been expanding. “There have been no blowups,few delinquencies, no scandals,” while rating agencies and gov-ernment regulators keep CMBS activity “under the microscope.”The CMBS markets have greater transparency “and can efficient-ly price risk,” helping maintain discipline. A conduit lender says:“I can’t think of any major threats to the business.”

Wow, it can’t be that good, can it? Well, no. “Margins arevery thin. Conduits seem to be reaching for business.”Interviewees expect CMBS yields to edge lower for all invest-ment-grade tranches. “It’s too late in the cycle to make below-grade CMBS investments—prices have been bid up beyond

comfort levels.” Interest rate shocks or geopolitical thunderboltsare a major risk since CMBS markets are tied directly to globalcapital flows—“money could rush out as fast as it has beenrushing in.” Problems with floating-rate borrower defaultscould dampen investor enthusiasm, if rate hikes occur ahead ofimproving property-level cash flows. Expect widening spreadsfor slightly worse credit performance when some B-piece buyersget hurt inevitably. In the event of any downgrades, BBB bond-holders and above should be well protected. These problemsshouldn’t create a crisis: “B-piece buyers to date have been wellcompensated for the added risk, and any losses have been mini-mal.” CMBS, meanwhile, retain their credit edge over compa-rable corporate bonds.

Interviewees continue to question what would happen inthe event of widespread delinquencies and defaults. With eyeswide open, borrowers knowingly accepted quicker responses onloan requests and larger loan amounts from CMBS lenders, giv-ing up future accommodations in servicing and workouts thatinsurance and bank documents typically extend. Special servicerreaction to mass defaults has never been tested and fears remainover how complex loan agreements and abrupt foreclosure poli-cies could lead to a tangle of lawsuits and uncertainty, cripplingthe market. “The industry is not complacent,” says a conduitlender. “We want to ensure that special servicers take theopportunity to make reasonable decisions.” Time will tell—most observers expect that the market can avoid substantial dis-ruption, which would force servicers to drop the hammer.

CMBS’s rising prominence in fixed-income markets increas-es investor interest in real estate debt. Investment managersbegin to develop funds, offering a diversified mix of CMBS,whole loans, mezzanine debt, as well as real estate equity andREIT stocks. These funds can provide more liquidity than typi-cal core real estate funds with similar income-generating charac-teristics and greater diversification. Asset allocators will quibbleover whether these hybrid funds fall under fixed-income or realestate in their models, but they will like the steady cash flowreturns. Levered finance techniques also ratchet up returns oninvestment-grade CMBS tranches. These collateralized debtobligations gain traction among sophisticated investors—institutional and high-net-worth individuals.


“Interviewees expect CMBS yields to edge lower for all investment-grade tranches.”

$0B

$20B

$40B

$60B

$80B

$100B

Issuance (left scale)

$0

$50

$100

$150

$200

$250

$300

$350CMBS Cap (right scale)

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90

Exhibit 3-11 CMBS Market

Sources: Federal Reserve, Commercial Mortgage Alert.

Note: Issuance data for 2004 include issuance for the first two quarters only.

Mezzanine DebtLess than a decade ago, mezzanine debt was a popular corpo-rate finance strategy that gained notoriety in highly publicizedcorporate buyouts and takeovers. Presto, “mezz” is a main-stream structure in the new world of real estate risk tieringbetween first mortgage positions, various CMBS tranches, andequity. Robust demand for mezzanine money extends from pri-vate investors and entrepreneurs, who have leveraged up modestequity stakes to outbid institutional investors and REITs in theproperty acquisition markets. The community of mezzaninelenders, meanwhile, has expanded dramatically to meet themarket—investment banks, mortgage companies, high-net-worth investors, and value-added funds all dole out mezz loans.

“Everybody is pushing the limit on standards, because of liq-uidity and competition,” says a mezzanine lender. “It’s hand-to-hand combat to out-hustle and get deals.” The result is compressedyields, increasing risk, weaker structures, and lower returns.

Some equity investors financially engineer acquisitions at“ridiculous cap rates” with little money down, take on mezzand floating-rate debt, and plan to get their money out andmore in a few years, “leaving the mezz lender holding the bag.”In reverse strategies, some mezz lenders consciously loan toown. “A lot of mezz loans are in trouble,” says an interviewee.“It’s not big news and handled quietly.” Sounds like mezzaninelenders may need a time-out, but some interviewees claim thatproperly underwritten loans still offer “the best risk-adjustedreturns available,” especially if space markets advance morequickly toward equilibrium.


MarketsMarkets


c h a p t e r 4

The roster of top investment markets remains a lonelyfour, similar to last year: Washington, D.C.; New YorkCity; southern California; and south Florida. “Big

money continues to go bicoastal,” says an interviewee. “MiddleAmerica is a hard sell. The nation’s economy and power appearfocused on the coasts. Smaller markets must make due on localcountry club money.” Not surprisingly, the favored few notonly have the best investment and development prospects, butalso feature the best supply/demand balance, according to sur-vey respondent rankings.

“Everyone reads the same reports, follows the same advice.”Stock analysts “tend to favor REIT companies concentrated intop markets,” extending the bias of pension funds and foreigninvestors to concentrate assets in these places. Not even a self-styled “avoid the herd” contrarian consultant can stop frombacktracking: “Well, you can’t avoid California—it’s too uniqueand important a market.” And while some interviewees recom-mend sidestepping the bicoastal land rush, few advise runningagainst it. “Let’s face it. In eight out of ten years New York willbe good for investors, while in Dallas it may be three or four outof ten, and in a place like St. Louis it may be one out of ten.”

Global Gateways StrengthenThe top Emerging Trends markets feature international gatewayswith barriers to growth, solid economic underpinnings, and adraw for immigrant labor forces. New York remains the world’sfinancial and cultural capital. Washington stands as cynosure ofglobal power. Southern California marries entertainment,defense, and biotech industries into an economic behemothastride the Pacific—the first port of call from the rising Asianindustrial juggernaut. The Miami area’s Palm Coast warmthdraws aging baby boomers, while proximity to South andCentral America attracts Latin businesses.

As technology and global capital flows integrate economiesand industries across national borders, cities and markets enjoybetter prospects if they can link their fortunes to the evolvinginternational growth path. Some regional centers get leftbehind, shunted off the beaten path. It’s the global version ofwhat happened to many U.S. towns and villages bypassed byinterstate construction in the 1950s and 1960s. Stagnation orworse, possibly Darwinian decline, faces some of these markets.

Watchto

“Everyone wants to

be in the same places.”

Washington (overall)

Washington, D.C.

Northern Virginia

Maryland Suburbs

San Diego

Los Angeles (overall)

Orange County

Riverside/SanBernadino

Los Angeles County

Miami (overall)

Fort Lauderdale/West Palm Beach

Miami/Miami Beach

New York (overall)

New York City

Newark/Northern N.J.

Westchester/Fairfield

Long Island

Las Vegas

San Francisco(overall)

San Francisco/San Mateo

Oakland/East Bay

Honolulu/Hawaii

Seattle

Sacramento

Boston

Phoenix

Tampa/St. Petersburg

Orlando

Chicago (overall)

Chicago City

Chicago Suburbs

San Jose

Austin

Baltimore

Atlanta (overall)

Atlanta (suburbs)

Atlanta (city)

Philadelphia

Charlotte

Jacksonville

Denver

Portland

Minneapolis/St. Paul

Houston

Raleigh

Nashville

San Antonio

Dallas/Fort Worth

Salt Lake City

Tucson

St. Louis

Memphis

Kansas City

Indianapolis

Pittsburgh

Milwaukee

Columbus

New Orleans

Cleveland

Detroit


“Cities with barriers to new development continue to gain favor over ‘hot growth’

Exhibit 4-1 Markets to Watch

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

Supply/Demand Balance

Development

Investment

6.876.076.356.946.346.836.715.665.936.415.546.26.575.836.156.255.726.156.475.816.116.316.1366.235.696.026.135.435.516.335.685.76.325.465.726.085.225.736.505.685.995.744.85.415.594.75.365.474.765.375.855.515.425.713.984.75.723.814.395.714.294.78

5.584.765.235.564.14.715.544.965.095.453.774.525.414.664.75.404.865.015.394.624.745.243.954.525.003.854.224.943.834.355.143.423.625.093.724.15.044.474.824.963.674.054.883.754.114.653.584.194.963.924.734.873.84.344.754.234.514.743.623.944.743.884.424.723.834.48

4.693.824.24.613.844.124.5944.424.574.174.624.533.553.764.433.634.314.383.984.474.203.614.433.993.524.133.973.824.33.873.214.053.813.414.233.793.253.943.623.093.673.522.983.763.362.733.763.292.933.63

Prospects for Commercial/Multifamily Investment and Development


Regional banks, businesses, and evenutilities consolidate as part of corporateGoliaths, which move to larger worldviewmarkets to maximize clout, attract thebest talent, and link to global networks.Even 24-hour standouts—Chicago andBoston—suffer recent serious losses offinancial company headquarters to merg-ers and acquisitions. Places without sub-stantial international airport hubs dimin-ish in significance. Back offices and facto-ries can locate almost anywhere now andtypically the low-cost provider wins(that’s often outside America). The deckis increasingly stacked against a KansasCity, Milwaukee, or Indianapolis, whichpales in comparison to American power-house markets, but also faces difficultiescompeting to attract commodity jobs inoffshore face-offs against Dublin, Manila,or places in India. At least Las Vegas has agambler’s chance: singular glitz and ersatzglamour make its Strip the internationaldestination for high rollers.

“Some secondary markets have netout-migration,” says an interviewee. “Ifpeople don’t want to live there, I don’twant to invest there.” Investors “worry”about growth drivers, so they “focus onthe larger cities” and the “coastal orienta-tion makes sense, because that is wherethe majority of the population and theopportunities are.” As capital flows, pop-ulation growth, and employment oppor-tunities gravitate to a confluence in selectregions, the opportunity to diversifyinvestments geographically becomesmore limited. The best markets offerbondlike returns, while the have-notsoffer nothing compelling—a lot morerisk and limited, if any, upside.

Follow the CrowdAn expanding market employment basecombined with geographic/planningrestraints offers the best investmentdynamic. For interviewees, that spells“southern California—the only placewith both.” But cities with barriers tonew development continue to gain favorover “hot growth” markets. New York,Washington, San Francisco, and Bostonare well positioned—they feature geo-graphic barriers, planning controls, andmodest employment growth prospects.Despite having expanding populations,Dallas, Houston, and Atlanta lose stand-ing, because of unrestrained developmentand poor growth management.

Pricing has been “outrageous” in theleading bicoastal markets, but “at leastfundamentals are relatively good.” Inother metropolitan areas, pricing hasbeen lower, “but still outrageous and thefundamentals have been lousy.” Investorsmay reluctantly “follow the crowd” intoWashington, southern California, andNew York, but interviewees say “the criti-cal mass” of capital provides “investmentliquidity,” allowing for future dispositionexit strategies and justifying pricing pre-miums. Just how rich pricing levels staylikely depends on interest rate moves. “Atsome point, T-bill yields will look betterthan the 5 percent and lower cap ratespeople are paying in these markets.” Fornow, these places “equal low risk, lowreturn, and low volatility” for investors.

Transportation access takes on addedimportance for corporations looking forheadquarters locations. “Hub airports areessential” for international travel. Chicago,Dallas, and Atlanta gain an edge here. Butavoiding the nightmares of traffic andlong commutes gives advantages to placeswith mass transportation networks. “It’sunreal how well Manhattan works because

of its subways, rail links, and bus systems.”The coastal markets also stand as

immigrant gateways, attracting hard-working, motivated newcomers who canenergize local workforces, fill servicejobs, and maintain a variegated flow ofprofessional as well as executive talent.Languishing cities fall further behind astheir best and brightest leave for greateropportunities elsewhere—again, thecoastal centers provide the greatest lure.

Overall, the established set ofEmerging Trends’ 24-hour market charac-teristics continues to drive the successand resilience of the most attractiveinvestment locations. These elementsinclude upscale infill neighborhoods nearcommercial districts, convenient pedes-trian-friendly retail, multifaceted recre-ation and cultural institutions—parks,museums, sports arenas, theaters andrestaurants—and transportation alterna-tives to the car. Strong economic under-pinnings inherent in the concentrationof major corporations and businessescreate the tax base to maintain infrastruc-ture and lure affluent residents with jobsand opportunities. Also of importance,crime remains tamped down in theseareas. As teen and young adult demo-graphic cohorts expand over the nextdecade after receding during the 1990s,low urban crime rates may be tested.

Halo EffectFavored market status extends in halos tosurrounding suburban areas. While down-town Washington, D.C., and Manhattanget higher survey marks, the Marylandand Virginia suburbs as well as theWestchester, northern New Jersey, andLong Island submarkets trail only slightlybehind the urban cores. Various southern


markets.”

California and south Florida submarketsalso cluster together in relatively narrowsurvey bands, testament to the nationalview that they comprise large, cohesive,and interdependent markets.

In suburban agglomerations, investorscontinue to choose submarkets with 24-hour characteristics over left-behinddowntowns without residential under-pinnings and fringe districts. Atlanta andDallas try, but so far fail to generateenthusiasm for expanding downtown res-idential development. In Atlanta, mid-town and uptown Buckhead are primeinvestment magnets—they boast affluentneighborhoods more convenient to mul-tifaceted recreational and retail environ-ments than either downtown or far-flungperimeter submarkets. Houston andespecially Denver make strides in estab-lishing more 24-hour downtown envi-ronments and take advantage of “themove-back-in trend.”

Hot Growth Markets CoolProspects for Sunbelt metropolitan areasmay hinge on further developing 24-hour infill environments. In the 1970sand 1980s, these markets mushroomedto accommodate the tsunami of babyboomers, moving south to temperate cli-mates away from flagging Rustbelt man-ufacturing areas and seeking a suburbanenvironment in which to raise families.As the number of empty nesters growsand their echo boomer children delaymarriage, the popularity of cul-de-sac


Survey respondents peg Washington, D.C., and a collection of southern

Washington (overall) Northern Virginia Washington, D.C.

Maryland Suburbs San Diego

Los Angeles (overall) Riverside/San Bernadino

Orange County Los Angeles County

Las Vegas Sacramento

New York (overall) New York City

Newark/Northern N.J. Westchester/Fairfield

Long Island Phoenix

Miami (overall) Fort Lauderdale/W. Palm Beach

Miami/Miami Beach Orlando

Tampa/St. Petersburg San Francisco (overall)

Oakland/East Bay San Francisco/San Mateo

Honolulu/Hawaii Atlanta (overall) Atlanta (suburbs)

Atlanta (city) Jacksonville

5.90

5.91

5.33

5.88

5.87

5.84

5.84

5.83

5.79

5.75

5.74

5.69

5.65

5.63

5.61

5.60

5.53

5.53

5.46

5.40

5.23

5.09

4.94

4.91

4.78

4.76

4.70

4.65

4.63

4.39

Chicago (overall) Chicago Suburbs

Chicago City Austin

Houston San Jose

Denver Seattle

Portland Raleigh

Dallas/Fort Worth Boston Tucson

Philadelphia Charlotte

San Antonio Salt Lake City

Nashville Minneapolis/St. Paul

Baltimore St. Louis Memphis

Kansas City Indianapolis

Columbus New Orleans

Pittsburgh Milwaukee Cleveland

Detroit

Exhibit 4-2 Markets to Watch

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

7.42

7.38

7.31

7.27

7.20

7.17

7.21

7.08

6.93

6.98

6.80

6.70

6.76

6.51

6.44

6.15

6.54

6.43

6.91

6.40

6.42

6.37

6.35

6.41

6.20

6.11

6.01

6.13

5.48

5.90

Prospects for For-Sale Homebuilding


homes could ebb, while the move backtoward vibrant cores gains momentum.The original allure of these cities—lowercost of living; large, modestly pricedhomes on big lots; easy suburbanlifestyles—has been diminished by trafficcongestion and the blight of sprawl.Many transplants don’t establish roots—they now look to resort retirement areas.

Company relocations may have peaked,too. Are these hot growth markets cool-ing down? The current economic growthcycle could answer that question. Allthese markets desperately need to expandtheir mass transit systems. Like Atlanta’sMARTA subway, nascent light-rail sys-tems offer help in Denver, Houston, andDallas, reinforcing opportunities forinfill development around stations.

HomebuilderChoices MimicInvestor PreferencesHomebuilding prospects, not surprisingly,track Emerging Trends investment trends,according to survey respondents. Resi-dential developers gain from barriers toentry, more vibrant local economies, andbuyer demand for higher-priced product.Growth markets may offer cheaper landprices and allow for easier entitlements,but they also tend to overbuild and deliv-er lower pound for pound pricing.Predictably, stagnating metropolitan areasbring up the survey rear. Survey respon-dents peg Washington, D.C., and a col-lection of southern California cities as thenation’s best homebuilding locationsdespite “bubble pricing.” Las Vegas andPhoenix, two suburban agglomerationsenjoying sizzling employment gains, sand-wich New York near the survey top. Theytrack ahead of popular Florida metropoli-tan areas, including Miami, Orlando, andTampa. Sky-high-priced San Franciscobeats out Atlanta and Chicago, two solidresidential markets recently suffering fromsoftened demand. Dallas (oversupply),Boston, and Philadelphia (hard-to-buildNortheast markets) score only mediocre rat-ings, while Detroit finishes last, just aheadof Pittsburgh, Milwaukee, and Cleveland.

The Best and the RestWashington, D.C.For the third consecutive year, thenation’s capital ranks as the country’snumber-one real estate market for invest-ment, development, supply/demand bal-ance, and homebuilding. When econom-

ic downturns hit, this recession-proofgovernment mecca always rises to the topof the survey. Now, the slow-motionrecovery helps keep the District ofColumbia on top. It may be real estate’sequivalent of Treasury bills. Regardlesswhether Republicans or Democrats con-trol this town, federal employees andlobbyist contingents proliferate. Budgetdeficits and tax cuts can’t slow thisengine down. Neither do the HomelandSecurity color-coded terror warnings. Infact, the metropolitan area leads thenation in employment growth anddowntown rates as the only U.S. officemarket with a vacancy rate below 10 per-cent. Office investors who bought threeyears ago at seeming nosebleed levelshave “hit the ball out of the park,”attracting “nutty” resale prices. But “aton of construction” tempers some out-looks. Condominium development “ison fire.” Maryland and Virginia suburbsscore well, too, “although prospectsdecline 20 miles outside the core.”Suburban office vacancies track downinto the less comfortable mid-teens.Apartment markets remain close to equi-librium. How long can this market “keepexceeding expectations”?

Southern CaliforniaSome demographers predict this PacificCoast powerhouse agglomeration couldadd the population of two Chicagos in thenext 20 years. Development pushes wellinto the desert—finding infill tracts andentitling them can be daunting. Affordablehousing remains difficult to locate even atthe fringes. Demand exceeds supply andannual home prices have appreciated 20percent or more in each of the past threeyears. Inland Empire and Orange Countytop national apartment markets. “For-salehousing is a no-brainer, but higher interestrates could slow things down.” If ever anarea promises to densify, southernCalifornia is it, NIMBY animus or not.San Diego noses out Los Angeles andOrange County as the region’s top market.Biotech, defense, and engineering-relatedbusinesses step up leasing. Downtownexpands residential neighborhoods,becoming “nearly a 24-hour city.” TheGaslight District and harbor offer delight-ful backdrops, while the 75-degree, blue-sky weather is always “perfect.” Down-town L.A. continues to struggle. “It’s a 24-hour city every three days.” The presenceof new high-rise residential oriented to sin-gles, a rail transportation hub, and DisneySymphony Hall suggests progress. But anabsence of schools and supermarkets indi-cates a lack of critical mass. Companiesfavor submarkets closer to high-end resi-dential neigborhoods like West L.A.,Century City, Glendale, and Pasadena.The less executives need to battle round-the-clock traffic congestion the better forthem. Regionwide, office vacancies remainin the mid to high teens. Rental increasesmay not register until year-end 2005 inSan Diego and mid-2006 in OrangeCounty. Los Angeles markets could takelonger. The L.A. basin features the nation’s


California cities as the nation’s best homebuilding locations.

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3

4

5

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Washington, D.C.

6.9

best industrial warehouse market withsub–5 percent vacancy. “L.A. and LongBeach ports continue to crank.” Retail is“unbelievable” and hotels are “fabulous.”Meanwhile, the country’s worst traffic andair pollution, looming water shortages, andthe state’s ongoing fiscal problems raise ques-tions about future quality of life that mayconfound even the Terminator, who hasmade some inroads in taming an “antibusi-ness” environment. But that’s the future.“Right now, I can’t think of a better place toown real estate,” says an interviewee.

South Florida Hot as a pistol, Miami and south Floridascore their highest Emerging Trends rankingever. Luckily, the area dodged direct stormdamage from Frances and Jeanne. Investorsrealize the area is hemmed in by geographicbarriers—the ocean and the Everglades.Buildout, fueled by both domestic and Latinin-migration, leaves limited developmentopportunities. A 30-year spurt of rampantgrowth has left the region a hodgepodge ofdensely packed suburbs with embeddedurban cores. “What does it tell you that theyare now building high rises between

Daytona and Jacksonville?” Hurricanethreats aside, coastal areas with ocean viewsand golf resorts are ground zero for babyboomers securing second homes for laterretirements—a smart move since demandwill only intensify for the best locations.Institutional investors and private buyersfocus on multifamily opportunities, drivingup prices. In Miami, too much condominiumconstruction crowds out office, which “offersbetter investment value.” Good airports, cul-tural diversity, and a vibrant Latin businesscenter link the area into international high-ways for commerce and tourism. Overall,the Florida story looks compelling—morethan 900 net new residents pour into thestate daily. Homebuilders love it. In Tampaand Orlando, tourists never seem to leave.The panhandle probably is the last, bestdevelopment opportunity remaining in theentire country. But the state must deal witha host of discomfiting issues: growth man-agement, water shortages, limited masstransportation, and care for increasing num-bers of seniors who live longer and depleteretirement nest eggs. “The elderly popula-tion is a mixed blessing—they don’t burdenthe schools, but they do stress the Medicaidsystem.” Higher taxes and critical infrastruc-ture issues loom like destructive tropicalstorms in the summer months. Some para-dise is still better than none.

New YorkThis global finance center “pounces atrecovery,” a good thing given the pricesbuyers have been paying on midtownoffice buildings. “All the investmentbanks” hunt for space to expand—“leas-ing could explode.” Bank of Americabuilds a major west side office project,“recognizing the city’s financial clout andinternational stature.” Goldman Sachsannounces a new downtown headquar-ters. Landlords with well-leased midtownoffice buildings start to gain leverage, sig-naling rent upticks ahead—market occu-pancies edge closer to a healthy 90 per-cent. Higher-risk downtown lags after9/11, but some interviewees like itspotential. By the end of the decade, anew transit center promises to improvetrain and subway access comparable tomidtown’s Grand Central and PennStation. “The government will continueto pour money in.” Residential conver-sions slowly transform Wall Street cav-erns. It’s by no means a 24-hour market,but stock traders now mingle with occa-sional dog walkers and even motherspushing baby carriages. Manhattan con-dominium and coop prices average northof $1 million—buying activity continuedthrough the stock market tumble andhasn’t stopped for a breather. Highermortgage rates promise to dampenenthusiasm and developers cut back onnew projects. Affordable housing remainsa major issue—luckily the city’s premiersubway and train system shuttles in serv-ice workers from surrounding boroughsand suburbs. Hotels rebound—occupan-cies zoom and room rates return tohealthy levels. The city weathers a budgetcrunch and round of higher taxes, butfailing schools remain a problem. Sub-urban housing markets may be overheated.


“Manhattan condominium and coop prices average north of $1 million.”

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Los Angeles

San Diego

6.6

6.3

0

1

2

3

4

5

6

7

8

‘04‘02‘00‘98‘96‘94

6.1

Miami

Office firms up with signs of improvedleasing on Long Island and parts ofWestchester County. The whole regionlooks solid. Caveat: if the stock marketmeanders and financial firms underper-form, forecasts could fall short.

San FranciscoThis classic 24-hour city “turns the cor-ner”—the office market finally realizessome positive absorption, and vacanciesslip below 20 percent. “Capital marketinflation” has maintained lofty officeprices, astonishing owners, who had pre-pared to take a bath. Many hold ontoproperties thanks to manageable debtservice. “Prices are crazy without an eco-nomic recovery.” Investors “bet that thecity will bounce back within three to fiveyears,” and hope that rent rolldowns fromstratospheric late-1990s levels (remember$100 a square foot? Try $35 today!) don’thurt too much. “Companies will comeback, attracted by the quality of life.”Planning controls and geographic reali-ties make development difficult.“Everybody wants view [of the Bay]space—these are irreplaceable assets.”

But south of Market Street “may waituntil 2015.” Apartments are oversup-plied, yet residential values have avoideddeclines, and retail beckons “a feedingfrenzy.” Silicon Valley looks like Houston1986—“a lot of empty buildings.”Interviewees expect a strong comeback…“eventually.” While the timing (“notimmediately”) is an open question, thecatalyst (high-tech businesses) is not.

Seattle“Past its worst,” this market has restartedin a “slow, broad-based recovery.” Boeingand Microsoft step up hiring after a peri-od of layoffs, “tech is stirring,” anddevelopment has held in check—severalmajor projects were mothballed or halt-ed. Office rent growth will wait until2006, but industrial should be sooner.“We’ll be ahead of San Francisco.”Concessions come down. SuburbanBellevue bounces back “more quicklythan anyone could have imagined.”Smacked around by high area unemploy-ment, apartments show signs of a turn-around. “Absence of significant masstransit is a major liability as traffic wors-

ens.” People “definitely look to workcloser to home.” National investors viewSeattle’s edge of the Northwest location“as far away” and “almost in nowhere.”But its Pacific Rim base makes for astrategic distribution center, facing primeAsian markets.

BostonLike San Francisco, Beantown has beenrocked by continuing job losses and ten-ant downsizings, but investors expect its24-hour characteristics to fuel a rebound.The market needs sustained growth in itsbread-and-butter financial/mutual fundcompanies to resuscitate it, and nervesfray over the impact of recent high-profilecorporate acquisitions from out-of-townbuyers: Fleet by Bank of America, JohnHancock by Manulife. Consolidationsand layoffs “could slow a quick recovery.”But mid-teen office vacancies head lower,and a financial district “leasing recoveryis underway.” “Terrible” suburbanoffice/R&D markets, including the


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6.1

New York

0

1

2

3

4

5

6

7

8

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San Francisco

5.7

0

1

2

3

4

5

6

7

8

‘04‘02‘00‘98‘96‘94

Seattle

5.6

“burned-out” high-tech 128 corridor,add a sobering note. Multifamily softensas employment growth sputters, butretail remains healthy. After a heady run,Boston looks like a mixed bag. “Youknow it will come back—it’s just a mat-ter of when.”

PhoenixThe best of the “hot growth markets,”Phoenix benefits from gains in new jobsand a concerted scaling back of develop-ment. “We’re not overbuilt for the firsttime in 50 years, other than high-endapartments,” says an interviewee. “Zerooffice is under construction, all the foodgroups look in relative balance.” A loss oflocal banks has “serendipitously” helpedthe market, constraining capital for newconstruction. Money center institutionssteer clear “because of the bad rap as aboom/bust market.” People, meanwhile,keep pouring into desert haciendas—forthe eighth year in a row, 35,000-plusnew homes were built, and the areaabsorbs 150,000 new residents annually.“Water is not an immediate problem.”New houses replace farms, reducing irri-

gation requirements, but what keeps allthose championship golf courses greenand 400,000 swimming pools full? Adesirable climate and reasonable cost ofliving attract retirees and snowbirds, withmore on the way. Scottsdale stands outas the agglomeration’s prime market,anchored by affluent residential neigh-borhoods. Downtown Phoenix is anafterthought—nobody lives there.

Chicago“No cheer in sight.” Overbuilding andhigh vacancy buffet the Windy City, whichperennially ranks as a top 24-hour market.Incredibly, the JP Morgan Chase takeoverof Bank One leaves this de facto Midwestcapital without a major bank headquarters.“Not much else besides law firms are grow-ing.” Free rent “has reared its ugly headdowntown,” while 20 percent–plus subur-ban vacancy “could take seven years to fillup even with modest growth.” Developerskeep erecting super Class A towers, whichsteal tenants from older Class A buildings.“More is on the horizon.” Tenants look tolock in low rents in the best possible space.“It’s a terrible landlords’ market.” But “tro-phy hunter, core” investors keep paying upfor well-located buildings. “It’s a vibrant

place and central national location with agreat airport.” Get a grip—all signals pointto a rocky few years. Condominiums andapartments also are overbuilt. For thelonger term, move-back-in strategies takeshape. Expect more office buildings nearthe lakefront to convert to residential withhigh-end condominium-style water viewsand good access to North MichiganAvenue shopping. Businesses prefer to clus-ter near primary train and subway stationsin the Loop. Development opportunitieswill increase just west of the Chicago River.These districts also feature better access tosuburban highways for commuters.

AtlantaInvestors wonder if Atlanta can recaptureits share of company relocations and sus-tain prodigious population gains. Growthand more growth fuel its engine—home-building, office and retail development,and road and infrastructure constructionhave been the region’s economic back-bone for more than 30 years. Hiringresumes, but not at a torrid pace.


“Phoenix benefits from gains in new jobs and a concerted scaling back of development.

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Boston5.5

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Phoenix

5.4

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5.2

Chicago

Horrendous traffic, sewer, and waterissues hamstring prospects and cloud thecity’s reputation. “Sprawlscapes” mar thesuburban idyll. “It grew up too fast, andnow no one seems to know what to do.”Housing and apartments are overbuiltacross the metropolitan area, but desir-able infill condominiums and townhousesin attractive midtown and Buckheadmarkets “get increasingly expensive.”Office investors gravitate to those mar-kets, too—“when it comes to Atlanta,you don’t want to be anywhere else.”Downtown hurts from lack of residential,an old story. At the city’s southern border,Atlanta’s busy international airportremains a sturdy ace in the hole, servingas a global transport hub and feeding anational distribution center at the junc-tion of important east-west, north-southinterstates. Logically, future developmentshould fill in between the airport anddowntown as northern suburbs nowextend within hailing distance of remoteTennessee and South Carolina borders.Atlanta’s future rests on whether it canredevelop a vital, multifaceted urban coreat the center of its suburban jumble.

PhiladelphiaLost in the glare of New York andWashington, Philly fails to register withmost investors. Office and residentialmarkets “are relatively stable and notvolatile.” Less charitable observers charac-terize the market as sluggish and stagnant.Several major tenants re-ink leases, but forless space. Downtown housing gets aboost from tax breaks, but high businesstaxes inflame corporate tenants and land-lords. Office vacancy appears manageable,but hotels are “disastrously” oversupplied.


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Atlanta

5.0

0

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2

3

4

5

6

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Philadelphia

5.0

DenverOuch—office “is out of whack,” vacancies“stink.” Denver needs “a new theme” toincubate an upturn and spur job growth.Energy businesses led an early-1980s growthwave before flaming out. Telecom droveprosperity during the 1990s, but “blew up”in consolidations and downsizings. “It’s agreat place for small- and mid-cap business-es to develop. But then someone buys themand moves them away.” Among suburbanagglomeration markets, the city takes thelead in creating a “wildly successful” down-town residential district in LoDo—restau-rants, shops, galleries, and apartments teemwith activity near the new football and base-ball stadiums. The pulsating district tapsinto demand from “the alive and well”empty-nester syndrome. “Its housing mar-ket is exploding” in “a paradigm shift to a24-hour microcosm.” No one discounts thepositive impact of the city’s expanding light-rail system to the suburbs and its LoDohub. The rest of downtown suffers demanddoldrums, while suburban markets wallowin a flood of empty space. Housing andmultifamily markets overshoot, “but notbadly.” Attractive Rocky Mountain lifestylesand a reasonable cost of living raise hopesthat demand can pick up, but the area sorelyneeds a catalyst.

Houston“The best of the Southwest.” Well, no.Austin actually rates higher. But whatdoes that say about Dallas? Office vacan-cies gyrate above 20 percent and apart-ments are overbuilt. Investors find solacein the Citgo headquarters relocationfrom Tulsa, an expanding downtownlight-rail system, and new downtowncondominium developments. But CBDresidential still lacks a critical mass. Theeasy-to-build environment and lack ofzoning controls concern institutionalinvestors and give a wide-open playingfield to homebuilders.

Dallas“Anybody can buy at 49th and ParkAvenue in Manhattan and not look bad,”says a Dallas developer. “Here it’s a timinggame, more challenging and fun.” Careto negotiate with that man? For manyinvestors, getting the timing right is moredifficult, and fun has been hard toachieve. “The window of opportunitykeeps narrowing. You’ve got to get in andget out faster and faster.” Submarketsoffer little distinction—“leasing comesdown to what’s cheapest for tenants.” Andyou want to be a landlord here? DFWAirport helps attract big corporations thatshy away from Austin, San Antonio, andeven Houston because of fewer directflights to key cities. Locals point to moregrowth—forecasts project close to 1.5million additional residents by 2010.Apartment and single-family developerslick their chops. But not so fast: Recentjob gains have been anemic—only 8,700new jobs were added in the one-year peri-od ending June 2004. Washington, D.C.,meanwhile, added 83,000, Phoenix


For Dallas, everyone recognizes the reality of out-of-control supply side.

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Houston

4.7

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4.7

Denver

42,000, and Houston 15,000. Theregion’s total lack of developmentrestraints—geographic or governmental—results in chronic overbuilding across allproperty types. Does office vacancy evertrack below 20 percent? For Dallas, every-one recognizes the reality of out-of-con-trol supply side. For 2005, the biggerissue is whether demand will reignite.

The RestLas Vegas receives high marks as themetropolitan area topping percentageemployment growth. How long canVegas buck the competition from newIndian tribe gambling enterprises andstates, looking to close budget gaps andenhance revenues? Wayne Newton singshis heart out to keep people coming.Honolulu gains from a rebound in theJapanese economy and weak U.S. dollar—foreign and domestic tourists are back.Sacramento strengthens off state capitalstatus and Arnold power. Tampa/St.Petersburg and Orlando benefit from theFlorida influx. Baltimore benefits fromD.C.’s aura and gains an enduring boostfrom harbor development. Austin’sgrowth controls have limited impact,since surrounding suburbs seem tosprawl anyway. But the Texas state gov-

ernment and University of Texas solidifyan increasingly attractive urban core.Charlotte and Raleigh stay in Atlanta’sshadow, but the Carolina corridor growsas an inviting retirement destination—except for all those hurricanes. Nashvilleand San Antonio don’t have scale or loca-tion advantages to get on radar screens.After Chicago, Minneapolis is the best inthe Midwest. Survey respondent ratingsscrap the Rustbelt, again.


0

1

2

3

4

5

6

7

8

‘04‘02‘00‘98‘96‘94

4.5Dallas

PropertyTypes inPropertyTypes in


c h a p t e r 5

Investment prospects improve across all property types for2005, compared with more tentative outlooks in the 2004Emerging Trends survey. Interviewees expect an expanding

economy to heighten leasing activity and increase occupancies inrecently challenged sectors—industrial, apartments, hotel, andoffice—and sustain solid returns in retail segments. Investmentratings cluster in a narrow sub-six band (on the Emerging Trendsrating scale, with one equaling abysmal to ten equaling out-standing) indicating modestly good near-term performance. (SeeExhibit 5-1.) As markets move closer to equilibrium and interestrates increase, investors may face the anomalous scenario of real-izing lower, albeit still very acceptable, risk-adjusted returns.Everyone will monitor capital flows and cap rate response to ratehikes. Development outlooks for 2005 improve marginally formost commercial categories, although office stays weak. Thespecter of rising interest rates fails to dim enthusiasm for home-building, which scores favorable modestly good to good ratingsacross most housing development categories led by infill/intownand moderate-income single-family housing.

PerspectiveCoupon Clippers FavoredSurvey respondents continue to favor core-return investments—industrial warehouse/distribution centers (5.9 rating), neighbor-hood grocery-anchored retail (5.9), and moderate-income rentalapartments (5.8). Given buyer demand and cap rate compres-sion, these sectors offer “modestly good” bondlike, coupon-clip-per income returns. Investors pay up for their predictable yieldsand steady performance. More volatile, full-service hotels (5.7)take the biggest survey leap. Interviewees anticipate continuedgains in occupancies and room rates to register from stepped-upbusiness travel and tourism. Enthusiasm lingers for all retail cate-gories, which have benefited from the enduring consumer push.Power centers enjoy their highest-ever rating (5.6), slipping aheadof regional malls (5.4), which also score improved marks over lastyear’s report. Office categories and R&D industrial face only“fair” outlooks. High vacancies and muted tenant demand por-tend an extended recovery. Overbuilt in many markets, high-income rental apartments receive relatively tepid marks (5.2).Limited-service hotels (5.0) always rank near the survey bottom—they’re too easy to build and always oversupplied.

“Infill and intown housing tops survey

development scorecards.”

optimistic forecasts. Investors will continue to pay premiumsfor well-leased downtown office over more commodity subur-ban. (See Exhibit 5-3.)

For 2005, hotels should garner the biggest gains in incomegrowth and appreciation, according to survey respondents andinterviewees. Office cash flows are expected to decline as rents roll


“Interviewees lean toward disposing hot retail sectors and high-income apartments

Predictably, warehouse, neighborhood shopping centers, andmoderate-income rental apartments score lower investmentrisk, while hotels, R&D, and office rate as dicier investmentplays. Deal cap rates generally fall in line with risk/return senti-ments: apartments, malls, neighborhood centers, and ware-house fetch the richest pricing ratios, while hotels lag despite

0Abysmal

5Fair

10Outstanding

Supply/Demand BalanceDevelopmentInvestment

Exhibit 5-1 Prospects for Major Property Types in 2005


Warehouse Industrial

Neighborhood/CommunityShopping Centers

Multifamily Rental–Moderate Income

Full-Service Hotels

Power Centers

Regional Malls

R&D Industrial

Multifamily Rental–High Income

Downtown Office

Limited-Service Hotels

Suburban Office

5.925.75.66

5.905.886.26

5.835.235.7

5.664.145.2

5.595.415.79

5.423.976.07

5.314.544.91

5.274.925.06

5.083.284.42

5.004.294.75

4.973.254.05

0Abysmal

5Fair

10Outstanding

Supply/Demand BalanceDevelopmentInvestment

Exhibit 5-2 Prospects for Niche and Mixed-UseProperty Types in 2005


Urban Mixed-Use Properties

Senior/Elderly Housing

Multifamily Rental–Tax Credit

Student Housing

Mixed-Use Town Centers

Lifestyle/Entertainment Centers

Resort Hotels

Master-Planned Resorts

6.01

5.94

6.15

6.00

5.91

5.9

5.98

5.85

6.16

5.94

6.06

6.16

5.91

5.9

6.04

5.77

5.88

5.88

5.71

4.78

5.33

5.68

5.62

5.75

down. Surveys also anticipate that downtown office values willstagnate, and suburban values will fall slightly. Other categoriesgenerally will realize only modest income and value increases.

Buy, sell, hold attitudes are mixed on the various property sec-tors, despite the survey’s strong overall sell signal. Interviewees leantoward disposing hot retail sectors and high-income apartments atapparent market zeniths, while holding other segments as marketsimprove. “Where else can you invest the proceeds?” Buying senti-ment is extremely subdued except for land acquisitions—“preparefor the next development wave.” Will capital flows catch on?

Development: CommercialBlahs, Housing FervorCommercial development activity may gain some momentumin 2005 given relatively dormant levels in most sectors, butinterviewee enthusiasm remains restrained. Except for apart-ments, new construction has been controlled and disciplined inthe face of uncomfortably high vacancy rates. Until marketsachieve better supply/demand balance, investors are morefocused on buying land, gaining entitlements, and planningprojects rather than funding construction. Above-replacement-cost pricing on industrials could encourage new warehousebuilding in some markets despite high vacancies. Any retaildevelopment will trend to recasting dated concepts or morph-ing failed malls. Most office is a nonstarter absent large anchortenants. Apartment builders will keep busy, anticipating anexpected demand surge.

Development outlooks for the housing markets stay morebuoyant. Optimism holds fast that interest rates will not risedramatically enough to abate demand driven by changing demo-graphic patterns and fervor for second homes. Interviewees keeptheir fingers crossed that hiring and wage gains materialize sothat even more Americans can satisfy the national homeowner-ship obsession.

Infill and intown housing tops survey development scorecards—the move back in toward 24-hour cores by empty-nester babyboomers and their out-of-the-nest offspring cannot be ignored.

Affluent baby boomers may downsize from suburban livingto smaller apartments and townhouses near urban action, butthey also seek vacation and weekend houses as well as condo-miniums, which can become their retirement homes. Leisurehome projects take off.

Traditional single-family housing projects should holddemand as long as interest rates remain manageable. Americanscontinue to aspire to big houses on big lots. But fasten yoursafety belts over the impact of higher interest rates on starterhome sales. Also, the baby boomer/echo boomer trends runcounter to Leave It to Beaver suburban lifestyles.

Master-planned and new urbanist communities tap into ris-ing homeowner demand for neighborhoods featuring moreintegrated land uses and access to convenient amenities. Peopleseem willing to pay premiums for better planning.


at apparent market zeniths.”

Exhibit 5-3

SPREADBID ASK (basis points) DEAL

Apartments–High Income 7.3% 6.6% 70 7.0%Regional Malls 7.6 7.0 60 7.2Apartments–Moderate Income 7.6 6.9 70 7.3Neighborhood/Community Centers 8.1 7.4 70 7.7Downtown Office 8.3 7.7 60 8.0Warehouse Industrial 8.5 7.7 80 8.0Power Centers 8.6 7.9 70 8.2Suburban Office 9.1 8.3 80 8.8R&D Industrial 9.3 8.5 80 8.9Hotels–Full Service 9.9 8.8 110 9.3Hotels–Limited Service 10.7 9.6 110 10.2


Capitalization Rate Characteristicsin 2004

Exhibit 5-4

Values % Income %

Hotels–Full Service 4.6 5.1Land 2.9 naHotels–Limited Service 2.8 3.1Neighborhood/Community 2.3 2.2Apartments–Moderate Income 2.0 2.1Warehouse Industrial 1.8 1.6Apartments–High Income 1.7 2.0Regional Malls 1.3 2.1Power Centers 1.1 1.6R&D Industrial 0.7 0.6Downtown Office 0.0 -0.2Suburban Office -0.5 -0.5


Expected Change in PropertyValues and Income in 2005

Industrial StrengthsA strong income play and relatively safe bet, warehouse invest-ments look like long-term bonds with excellent risk-adjustedreturns. Owners “always have an exit strategy.” Core buyerdemand, especially from institutions, seems “insatiable,” fortify-ing values. Despite lingering high vacancies—above 10 percentin many markets—rents hold up. Newer, high-ceiling productin major hubs fares much better. As company inventoriesrebuild and the economy improves, occupancies will rise.“Industrials track the GDP, and should do well at this point inthe cycle.” Offshored manufacturing doesn’t affect domesticdelivery since imported goods still need distribution networks.

Weaknesses“Cap rates are so low, you can’t afford to buy.” Some recentpurchasers may have overpaid. “Pricing is over their skis.”Vacancies “are too high to feel warm and fuzzy.” Industrialsusually lead a real estate market rebound, but the economyhasn’t cooperated—yet. Watch out for new development,

which could delay full-scale recovery. Construction may ignitein some markets, given pricing for existing product well abovereplacement costs. Investors have trouble accumulating sizable-enough portfolios to provide adequate diversification. In thecurrent low-cap-rate environment, small one-off deals, whichfail to create critical mass, rate as “the most overpriced realestate.” “To buy meaningful portfolios, you must take the lemonsmixed in with the cherries.” Just-in-time technologies continue toerode viability of “old school” warehouse space. “Be careful, theseare not necessarily buy-and-hold-forever investments.”

Best BetsAcquire or hold new, higher-ceiling space—24-foot clear isminimum, 30-foot clear is better. Wide turning radii and ampleparking for oversized trucks are essential. Tenants want spacethat facilitates distribution, not storage. Concentrate on coastalintermodal markets—near ports, airports, rail lines, and inter-states. Confluence points are ideal. “Follow the path of goodsmovement for the best locations.” Investors gravitate to thetop-tier “big box” markets, typically near 24-hour cities, whichservice primary population centers: Los Angeles/Inland Empire(numero uno), northern New Jersey, Chicago, and SanFrancisco. Miami and Seattle are also strong plays. Two impor-tant air/interstate hubs, Atlanta and Dallas, get marked downfor “absent development constraints” and “excessive supply.”


“Vacancy rates remain stubbornly high for the sector, but will edge below 10 percent

Exhibit 5-5 Prospects for WarehouseIndustrial in 2005

Prospects Rating Ranking

Investment Modestly Good 5.92 1stInvestment Risk Modestly Good 6.08 1stDevelopment Modestly Good 5.70 2ndSupply/Demand Balance Modestly Good 6.26 5th

Expected Income Change 2005 1.6%Expected Value Change 2005 1.8%Deal Cap Rate 2004 8.0%

Buy Hold Sell37.9% 34.9% 27.2%


–3%

0%

3%

6%

9%

12%

15%

‘04 2Q

‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 5-6 NCREIF Warehouse Returns

Source: National Council of Real Estate Investment Fiduciaries (NCREIF).

*2004 returns are four-quarter trailing figures as of second-quarter 2004.

AvoidOlder lower-ceiling, long-term storage space is extremely vul-nerable. Tenant requirements—super-flat floors, flexibility forracking systems—have “become more funky, driven by logisticstechnologies.” Obsolescence risk increases with developerappetites. Sell out or look to redevelop, if you can.

Secondary and tertiary warehouse markets fall victim toinvestor tunnel vision for overweighting major hubs. New dis-tribution schemes also continue to cut out warehouse links andreduce demand for space in more fringe areas.

DevelopmentDevelopment offers opportunities with better rates of returnthan buying existing product. Recent buyers have paid wellabove replacement cost. New projects can offer bells and whis-tles, undercut existing competition on rents, and operate at alower cost of capital. “Get good sites and entitlements.” First-wave projects could score on long-term leases, before marketsget overheated. Focus on the top markets.

Warehouse OutlookVacancy rates remain stubbornly high for the sector, but willedge below 10 percent in 2005. Development plays the wildcard, potentially offsetting increasing tenant demand with newsupply. Pension fund appetites will help support values, but

steamy pricing may level off. An improving economy can onlybenefit the industrial markets. No wonder this sector regainsthe top investor sector ranking.

R&D OutlookInterviewees pan “weird” R&D: “Hate it, just hate it.” “Whatis it there for?” “Just lousy.” Hmmm. Doesn’t sound good, butmaybe it’s time to make a contrarian move. Historically, per-formance can accelerate quickly when high-tech businesses startexpanding their operations—early 1980s and mid-1990s R&Dreturns were off the charts. R&D performance has slumped forfour years, but returns have begun to recover after bottomingout in 2002. “Painful consolidations are over.” 2005 may be a good year to rummage through the tech-wreck remains.Software, hardware, and chip companies remain America’s besthope for energizing the economy and a comeback is inevitable.“At the very least, tight-fisted businesses will need to reinvest inIT to stay competitive.” Some 20-something genius in a SiliconValley flex office cube will figure out the next new something.“You’ve got to believe in the long-term health of R&D, it’s justa matter of when.” But next time, when your investment inthat oddly configured R&D building starts delivering 20 per-cent–plus returns, just sell as quickly as possible.


in 2005.”

Exhibit 5-8 Prospects for R&D Industrial in 2005


Investment Fair 5.31 7thInvestment Risk Fair 5.16 9thDevelopment Fair 4.54 6thSupply/Demand Balance Fair 4.91 8th


Buy Hold Sell26.4% 41.1% 32.5%


4,000

7,000

10,000

13,000

16,000

‘04 2Q

‘02 ‘00 ‘98 ‘96 ‘94

Exhibit 5-7 Warehouse Construction Put in Place

Mill

ions

of D

olla

rs

Source: U.S. Census Bureau.

RetailStrengthsRetail is the only property sector in relative equilibrium. Develop-ment still trends down after hitting near-record highs in the late1990s. Consumer spending has been mind boggling, bolstering“strong credit” retailers that fill malls and power centers. Evendinosaur department stores resuscitate in the shop-till-you-dropfury. “Just as real estate people get rid of a Mercedes as a last resort,Americans give up going to the regional shopping center only ifthey have nothing to spend.” Shoppers have been “using theirhomes as giant ATMs.” After all the tax cuts and mortgage refi-nancings, future growth now depends more on whether the econo-my produces new jobs with higher wages. Interviewees are reason-ably encouraged. Huge value increases may be over, but fortressmalls pump income and infill-neighborhood centers, sheltered fromnew competition, print cash. You know the old story: Everybodyneeds that quart of milk and pound of hamburger meat.

Weaknesses“Pricing has been incredible without regard to risk.” At thispoint, any investments are pure income plays—and length ofretail leases holds back the rate of growth. Interviewees worryabout the nation’s “excessive credit card debt.” Retail missed thelast recession, but consumer spending may take hits from high-er energy prices and rising debt service costs. Mall REITs cor-

ner the market on regional centers and shopping center REITsmake inroads at controlling better grocery-anchored portfolios.Good buying opportunities “are few and far between.” Shortconsumer attention spans force costly capex changes in retailformats, which then “get stale after three visits. When will teareplace coffee?” As if Wal-Mart incursions weren’t enough of acompetitive haymaker, now Target and other discounters enterthe supercenter market, further threatening weakened grocery

anchors. Supermarket balance sheets look shaky. A chain bank-ruptcy and/or mass store closings “could change everybody’sview of neighborhood retail very quickly.”

Best Bets“Hold, hold, hold” the 200 or so fortress malls. Cap rates staylow. “It’s all academic, since major mall REITs vacuum up mostof the best centers” and “never sell or harvest returns.” Don’twaste your time trying to buy a market-dominant mall. One-off buyers can’t compete against the big public owners in acqui-sitions or leasing. “The big guys have too much clout.” Ownerswith small mall portfolios should take the opportunity to sellout or joint venture with a REIT powerhouse, which can usesubstantial portfolio leverage to sign up the best tenant lineupsfrom major national chains. Consider disposing of all non-strategic assets.

Sell B and C malls at market top. “Many of these centershave no reason to be in business,” says a REIT CEO. Despitethe recent buying flurry for anything with a lighted food court,all the established downward trends—death spiral competition


“Retail is a solid hold, but a better sell.”

Exhibit 5-9 Prospects for Neighborhood/Community Shopping Centers in 2005


Investment Modestly Good 5.90 2ndInvestment Risk Modestly Good 6.02 2ndDevelopment Modestly Good 5.88 1stSupply/Demand Balance Modestly Good 6.26 1st


Buy Hold Sell28.9% 32.0% 39.1%


Exhibit 5-10 Prospects for Power Centers in 2005Prospects Rating Ranking

Investment Modestly Good 5.59 5thInvestment Risk Modestly Good 5.63 5thDevelopment Fair 5.41 3rdSupply/Demand Balance Modestly Good 5.79 3rd


Buy Hold Sell14.3% 28.2% 57.6%


from fortress centers, high capital costs for little return, bleed-ing tenants—kill prospects for weaker malls. Buyers need toimplement rational reuse schemes or will take a bath. Second-or third-tier centers with good access, visibility, and parking canbe redeveloped into power or lifestyle centers or mixed-useprojects with residential and retail components. “Their value isno longer as regional centers.”

Sell power centers. They remain vulnerable to retailDarwinism, if consumers cut back and category-killer profitstake a hit. Cap rates are too low under any circumstances.Despite higher risk from potential loss of big-box tenants, thesecenters are priced almost like grocery-anchored retail. Be selec-tive about investments in popular lifestyle centers, which aresprouting in many locations. The market is definitely movingin this direction, but the formula is not as tried-and-true as thatof other retail formats.

Sell neighborhood centers with weak supermarket anchorsand/or located in markets vulnerable to supercenter incursions(areas with sites big enough for a stand-alone hypermarket).Watch the three- to five-mile radius Wal-Mart “kill zone.” Aminority view suggests scoping out markets already invaded byWal-Mart to acquire neighborhood centers left standing afterthe dust has settled. “The damage will have been done.”

Avoid“Paying up for neighborhood centers is like playing Russianroulette.” Investors may get yield, but the Wal-Mart threat is ahuge risk at current pricing. In general, “retail has been over-

played.” Survey respondents and interviewees warn aboutpower centers, too: only 14 percent of survey respondents saybuy versus a 58 percent call to sell.

DevelopmentAmerica is still grossly overretailed on a sales-per-capita basis,but new strip centers and power centers keep getting built.Investors should focus on redeveloping tired or failed concepts,rather than bankrolling new construction. “Do we really needany more Home Depots or Bed Bath & Beyonds for a while?”Built-out suburban areas call for infill rehab concepts to revital-ize badly aging corridors of strip centers. Lifestyle retail inmixed-use developments offers good potential to tap into theaffluent move-back-in crowd. Developers bulldoze any linger-ing notions for new regional malls. With few exceptions, envi-ronmental and land use restrictions make these projects unten-able in many places. Entitlements take forever.

OutlookAmericans spent through the last recession. Maybe finally theywill need to take a breather in 2005 as fiscal stimuli—namely,the effects of tax cuts—lose some punch. A modest economicexpansion may not offset temporary consumer fatigue, maxed-out credit, and higher gas and heating bills. Expect stabilizingproperty values and cash flows. Investor returns settle down toearth, facing more downside risk than opportunity for furtherupside. Retail is a solid hold, but a better sell.


Exhibit 5-11 Prospects for Regional Malls in 2005Prospects Rating Ranking

Investment Fair 5.42 6thInvestment Risk Modestly Good 5.68 4thDevelopment Modestly Poor 3.97 9thSupply/Demand Balance Modestly Good 6.07 2nd


Buy Hold Sell9.1% 38.0% 52.9%


–5%

0%

5%

10%

15%

20%

‘04*2Q

‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 5-12 NCREIF Retail Returns



ApartmentsStrengthsEven if doctor syndicates back off as expected, institutionaldemand will stimulate ebullient pricing. Like industrials, buyersare never in short supply—the capital market risk is less thanthat for either office or retail. Higher mortgage rates heartenmultifamily investors: would-be homebuyers may shelve plansand keep renting. Any economic gains boost renters’ situations,too: echo boomers can leave home or stop doubling up.Concessions and free rent periods start to wear off in manymarkets. Everyone loves the demographic profile: the youngadult renter cohort proliferates. “Baby boomers’ kids are start-ing to graduate from college” and marry later. “You have a ten-year window of opportunity before a drop-off.” Although richlypriced, multifamily is “a great coupon clipper.”

Weaknesses“Just say ‘no’ for the next two years.” Capital markets have“ignored the punishment” to rental rates. Some rental growthassumptions can’t be sustained and new construction has notslowed since the early-1990s recession. “Pricing has already fac-tored rental growth from rising interest rates.” Multifamilypricing is “almost absurd” at sub-six cap rates without anydiminution of new supply—developers continue to build.Institutions look to tertiary markets to force money out.Property values may flatten. Delinquencies have not peaked.

Best BetsFocus multifamily acquisitions on B and C apartments in high-cost housing markets with ample demand from permanentrenters: southern California, the San Francisco area, the entireNortheast 24-hour market megalopolis, and Chicago.Concentrations of prime immigrant renters support these mar-kets, where entry-level buyers will be priced out of homeowner-ship. Hold these investments to tap into increasing renterdemand, and sell over the next five to seven years when thegeneration Y demographics start to look less favorable. Theseinvestments could be excellent value plays.

Condominiums make sense in high-cost housing marketslike New York, D.C., and San Francisco. South Florida showstemporary signs of overbuilding and high levels of speculativebuying, but over time anything with water views and barriersto entry works. Hurricane trauma also tends to remedy quickly.Baby boomers/empty nesters have lifestyle visions of urbanpied-à-terres within walking distance of cultural institutions


“Apartments will come back, but not real fast.”

Exhibit 5-13 Prospects for Moderate-IncomeApartments in 2005


Investment Modestly Good 5.83 3rdInvestment Risk Modestly Good 5.85 3rdDevelopment Fair 5.23 4thSupply/Demand Balance Modestly Good 5.70 4th


Buy Hold Sell33.2% 34.7% 32.1%


Exhibit 5-14 Prospects for High-Income Apartments in 2005


Investment Fair 5.27 8thInvestment Risk Fair 5.32 6thDevelopment Fair 4.92 5thSupply/Demand Balance Fair 5.06 7th


Buy Hold Sell17.3% 34.0% 48.7%


and fine restaurants and wintertime retreats with ocean vistasnear golf courses. But be careful—“condominiums are poppingup all over the place.”

AvoidHigh-end condominium conversion plays in hot growth hous-ing areas like Dallas and Atlanta. In these metropolitan areas,higher price points attract a limited market and higher interestrates could curtail already weak demand. Lower price pointsmay sell better, attracting singles and empty nesters, “but notat $500,000.” Converters get left with expensive rental units,which can go begging. “If you own apartments, that will beyour competition.” Chicago’s condominium market is alsooverdone. “Everybody and his grandmother call me every dayfor condo financing,” says a mezzanine debt investor. “Youknow it’s time to get out” or at least back off in many markets.

DevelopmentThe multifamily sector always puts the touch on constructionlenders. “It’s the one property sector where developers can geteasy money.” Less disciplined local banks can swallow the mod-erate loan amounts. Despite renter softness, developers buildmore than 450,000 units, up from about 400,000 in 2001.Affordable housing shortages run rampant nationwide, buthigh-end product is overbuilt. Demand will increase for moder-ate-income projects as mortgage rates creep ahead. Finding andentitling sites in prime infill areas becomes an increasing chal-lenge. Any projects in southern California almost cannot miss,but it’s tough to win approvals.

OutlookFor 2005, interest rates may not rise enough and job growthmay not be strong enough to hasten renter stampedes.Undeterred developers keep raising hurdles to bettersupply/demand balance. “It may take another year to sort out.”Apartments will come back, “but not real fast.” People needmore security to leave parents and roommates. But for thelonger term, “apartments make a good defensive play—demo-graphics and interest rates provide a tailwind.” Multifamily“will correct the best.”


300,000

350,000

400,000

450,000

500,000

‘04 2Q

‘02 ‘00 ‘98 ‘96 ‘94

Exhibit 5-15 Multifamily Housing Starts

Units

Source: U.S. Census Bureau. Data include for-sale condominiums.

–3%

0%

3%

6%

9%

12%

15%

‘04*2Q

‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 5-16 NCREIF Apartment Returns



OfficeStrengths Space markets bottom out. Owners sit comfortably, holdingwell-leased 24-hour downtown office, if their short-termrollover risk is limited. Low-cost leverage enhances theirreturns. “The market is two-tiered: trophy and everything else.”Companies have either subleased or absorbed a majority ofphantom/shadow (unused/leased) space, which had softenedoccupancies and deterred new leasing. Now tenants can fillvacant space as the economy picks up. “The switch will go onfor big companies to make deals in late 2004 and early 2005.”Low finance rates give owners breathing room to wait out thedecline, and sell when tenancy firms and cash flows improve.

WeaknessesCommodity suburban office drowns in high vacancy (still 20percent–plus in some markets). Owners pray for a quick eco-nomic burst, but job growth questions furrow brows and testrecovery forecasts. “The fundamentals create an uncomfortablefeeling.” Despite low rents and a tenants’ market, investors can’tfind bargains. “Six to seven cap rates for office buildings in thesekinds of markets can’t be justified.” Even some tertiary locationshave high prices. Rents roll down, lowering net operatingincomes as old leases burn off. Some owners “give space away”after factoring leasing commissions, tenant improvements, andhigher operations expenses. “When tenant rep brokers get exorbi-tant commissions, it’s a sure sign of a weak market. Landlords aregetting beat up.” Tenants have plenty of options to upgrade spaceand realize it is time to ink leases at the lowest possible rates.Landlords face a Hobson’s choice of higher vacancy or unfavor-able lease terms—they have limited pricing power until 2006.Office REITs re-sign tenants to keep up occupancy and currentcash flows, and reduce potential broker leasing costs. At least,activity has picked up.

Besides their various outsourcing strategies, companies con-tinue to dramatically shrink space per employee requirements“and workers have come to accept” more cramped environ-ments. “I’ve moved into a cube,” says an interviewee, who usedto work in an L-shaped corner office with all the trappings. “Ican see everybody, interact more, and create more opportuni-ties. If I need privacy, I have a wireless headset and can moveinto a private conference room. It’s all very cool.” The days ofcoddling employees with running tracks, gyms, and otheramenities are over. “Lower-cost structures are in.” It all comesdown to “using less space.”

Best BetsIf you haven’t leveraged up trophy core downtown buildingswith coveted credit-tenant rosters, do it now while rates are stillrelatively low. “You may not get another chance to arbitragereturns like this…ever.”

Some owners will crater in defaults under cash flow short-falls. Keep circling for opportunities.

In Sunbelt meccas like Dallas, Atlanta, Denver, and Phoenix,the buy/lease-up/flip cycle may have turned the corner: “It’s timeto buy cheap, capitalize cheap, and figure out what to do with itlater.” These markets may benefit as corporations continue to


“Office will underperform other property sectors.”

Exhibit 5-17 Prospects for Downtown Office in 2005


Investment Fair 5.08 9thInvestment Risk Fair 4.96 10thDevelopment Poor 3.28 10thSupply/Demand Balance Modestly Poor 4.42 10th

Expected Income Change 2005 –0.2%Expected Value Change 2005 0.0%Deal Cap Rate 2004 8.0%

Buy Hold Sell21.7% 42.6% 35.7%


Exhibit 5-18 Prospects for Suburban Office in 2005


Investment Fair 4.97 11thInvestment Risk Fair 4.55 11thDevelopment Poor 3.25 11thSupply/Demand Balance Modestly Poor 4.05 11th

Expected Income Change 2005 –0.5%Expected Value Change 2005 –0.5%Deal Cap Rate 2004 8.7%

Buy Hold Sell23.9% 37.0% 39.1%


decentralize workforces domestically. Investors count on localjob creation engines to fire up. Although customer-focusingheadquarters stay in coastal prime markets, technology enablesseparation of workforces to cheaper places in domestic loca-tions. “It doesn’t sound new,” says a tenant rep. “But it’s reallycaught on now at the CEO/CFO level.” Concentrate on find-ing value in primary suburban office hubs, and stay away fromcommodity buildings. Remember: once properties lease up, sellthem quickly.

AvoidFringe, commodity buildings. “Class C is challenged and theeconomy will no longer expand you out of trouble.” Officespace must be able to accommodate technology systems andopen floor designs that allow tenants to maximize efficiencyand reduce employee space per capita. Owners should considerreuse strategies.

DevelopmentWhew! New construction has slumped. Can you believe: “It’sliterally nonexistent in the Southeast and Southwest?” “Officedevelopment is a nonissue for the next three to four years.”Slack building activity cheers optimists, who predict marketequilibrium could return faster than expected.

OutlookOffice will underperform other property sectors. Owners hopefor a repeat of 2004—values hold and tenant activity keepsimproving. Cap rates will adjust modestly to account for lowerinvestment cash flows. Two good years of absorption are neededbefore rents increase. Most interviewees delay recovery forecastsuntil 2006 and 2007, depending on the depth of current marketdistress. Negligible new construction helps to firm up markets.


0

10,000

20,000

30,000

40,000

50,000

60,000

‘04 2Q

‘02 ‘00 ‘98 ‘96 ‘94

Exhibit 5-20 Office Construction Put in Place

Mill

ions

of D

olla

rs


–15%

–10%

–5%

0%

5%

10%

15%

20%

‘04 2Q

‘02 ‘00 ‘98 ‘96 ‘94 ‘92 ‘90 ‘88 ‘86 ‘84

Exhibit 5-21 NCREIF Office Returns



5%

10%

15%

20%

25%

Suburban

CBD

‘04 2Q

‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90‘89‘88

Exhibit 5-19 Office Vacancy Rates

Source: Torto Wheaton Research.

HotelsStrengthsPeople have bought all the cars, clothes, and things they can;now why not take trips? Leisure travel escalates to record levels—people feel safer in the United States and the weak dollar cur-tails overseas excursions. Business travel also bounces back afteran extended lull. CFOs loosen budget strings for meetings andconferences…finally. “A full-swing expansion in lodgingdemand” propels revenues, while modest construction activitykeeps supply in check. Key hotel performance indicators—aver-age daily room rate and revPAR—leap ahead, especially in theluxury and upscale full-service categories, flirting with 2000

peaks. Occupancies in the low 60 percent range jump wellabove break-even. Hoteliers celebrate restored pricing power.“It’s tough to find rooms again.”

WeaknessesMany owners deferred maintenance in the post–9/11 slide.Some revenue gains require diversion to sprucing up rooms andpublic areas. “That peeling wallpaper and frayed carpeting needto be replaced, and so do the lumpy mattresses.” Many institu-tional owners steer clear—running hotels is too managementintensive and specialized. “All I want to know about them iswhen I check in and check out,” says a pension executive. “It’stoo tough a business to invest in” with labor issues, marketingheadaches, and constant capital needs. Owners and managersstruggle to align interests. Limited-service hotel fundamentalsimprove somewhat, but interviewees permanently dismiss thesegment as overbuilt and not worth the trouble. Event risk canshort-circuit travel demand overnight.


“Hoteliers celebrate restored pricing power.”

Exhibit 5-22 Prospects for Full-Service Hotels in 2005


Investment Modestly Good 5.66 4thInvestment Risk Fair 5.19 8thDevelopment Modestly Poor 4.14 8thSupply/Demand Balance Fair 5.20 6th


Buy Hold Sell34.4% 42.1% 23.5%


Exhibit 5-23 Prospects for Limited-Service Hotels in 2005


Investment Fair 5.00 10thInvestment Risk Fair 5.21 7thDevelopment Modestly Poor 4.29 7thSupply/Demand Balance Fair 4.75 9th


Buy Hold Sell19.6% 42.0% 38.4%


Best BetsAll signals point to buy or hold. “Opportunity capital is all overthis market,” focusing on upscale segments. “Don’t expect anyhuge bargains.” The good “fly-to markets”—San Francisco,Boston, New York—offer the most solid opportunities in thesought-after full-service categories. Luxury-oriented resorts caterto growing numbers of baby boomers, who have more dispos-able income and time to travel.

AvoidWhen in doubt, investors should shy away from lodging invest-ments. Operators and savvy specialists could clean up in thecyclical upswing, but asset allocators and safe harbor investorsshould stick to the four basic food groups.

DevelopmentNew construction drops to mid-1990s levels. Lenders andinvestors backed off big time in the chill of 9/11 and the IraqWar. Now opportunity exists in recovery. “But you needcourage and can lose a lot of money.” Hotel developmentrequires “skilled investing”—it’s high risk. Expect activity toramp up.

OutlookHotels should outperform other property sectors with a solid“two- or three-year run” of advances in net operating income,before new supply begins competing. Terrorism adds more riskto real estate’s most volatile sector, and sustained higher energycosts would deter some travel. But overall positive economicsigns suggest you’ll have good time, if you book some capital atthe inn.


0

5,000

10,000

15,000

20,000

‘04 ‘02 ‘00 ‘98 ‘96 ‘94

Exhibit 5-24 Hotel Construction Put in Place

Mill

ions

of D

olla

rs


HousingStrengthsAs long as interest rates stay reasonably low, more Americans canbuy starter homes, upgrade to bigger houses, or purchase vaca-tion properties and weekend retreats. Heads spin when next-door neighbors sell out at stupendous prices. Remember whenMom and Dad bought the two-bedroom, two-bathroom capefor $10,000 in 1955? Now it’s worth $500,000! Homeowner-ship takes on meaning beyond shelter and a place you can callyour own. It’s Americans’ number-one investment asset andalmost a national imperative. The stock market malaise contin-ues, who knows from bonds, and you can’t depend on the 401Kanymore. The home evolves from nest to nest egg. Various gov-ernment subsidies and time-honored tax breaks continue to pro-vide extra thrust to demand drivers. Upper-income baby boomersexpand the second-home market.

WeaknessesOwnership levels may have pushed the limits—almost 70 per-cent of Americans live in their own homes. That’s extraordinary!Some recent buyers of starter homes borrow no-to-low equitydown with adjustable terms at basement-level mortgage rates.These folks—stretched to the limit on car payments and familybills—count on property values to keep escalating. But higherinterest rates and rising mortgage payments make them particu-larly vulnerable to default. Middle-class families get squeezed byhigher health care costs and flattening wage gains, while thenational poverty rate edges up. Higher energy costs crimp calcu-lations about carrying mortgages. Will the end of low interestrate nirvana tap out the buyer market? Construction costs rise,pushing up new house prices. Developers could face resistancein passing on costs.


“Housing markets appear in very good supply/demand balance.”

0Abysmal

5Fair

10Outstanding

Supply/Demand BalanceDevelopment

Exhibit 5-25 Prospects for For-Sale Housing in 2005


Infill and Intown Housing

Detached Single-Family(Moderate Income)

Second and Leisure Homes

Detached Single-Family (High-Income)

Attached Single-Family

Master-PlannedCommunities

MultifamilyCondominiums

New UrbanistCommunities

Golf Course Communities

6.88

6.75

6.82

6.59

6.55

6.23

6.46

6.12

6.39

6.32

6.18

6.26

6.14

5.87

5.83

6.04

5.29

5.31

Best BetsHigher interest rates and price points won’t affect more affluentbaby boomers as much. They anticipate lifestyle change hungri-ly and look to comfortable retirements. The leisure and second-home market has legs. Proximity (two to three hours’ drivingdistance) to urban centers is highly desirable—these people stillwork. Grandma and Grampa also want grandkids close by.Recreational areas with water views are golden.

Suburban areas will become denser and more urban as com-munities cope with traffic congestion and infrastructure issues.People will pay premiums for master-planned communities thatoffer them amenities and convenience: pedestrian-friendly placeswith accessible retail, parks, and recreation, as well as mass trans-portation alternatives to the car. Suburban boomers gravitate toage-restricted townhouse developments, needing less upkeep andhassle, but ample comfort for childless households.

Growing generation Y numbers headed to college and gradschools make student housing a good short-term play.

AvoidDemand could wane temporarily for starter homes on the sub-urban edge if interest rate increases offset job and wage growth.Commuting times and gasoline costs could start to put limitson how far areas can expand comfortably—unless, of course,you live in Dallas.

Don’t bury the boomers yet. It’s still too early to get on thebandwagon for assisted living projects.

OutlookAfter eight consecutive years of record existing family homesales and a burst of housing starts that rival the go-go late1970s era, the average observer might think that homebuyingcould slacken, especially as interest rates start to increase. Buthousing markets appear in very good supply/demand balanceand interviewees do not expect mortgage rates to advanceenough to stanch buyer enthusiasm, at least not in 2005.Interest rates will tell the story. If they rise too far too fast, thebubble deflates. Home values may start to level off for a while.


500,000

1,000,000

1,500,000

2,000,000

‘04*‘02‘00‘98‘96‘94‘92‘90

Exhibit 5-26 Single-Family Housing Starts

Units


Note: Figure for 2004 is the seasonally adjusted annual rate for the first eightmonths.


Interviewees/Participants The Ackman-Ziff Real Estate Group, LLCGerald S. CohenRussell SchildrautSimon Ziff

AEW Capital Management, LPMichael J. ActonDouglas M. Poutasse

AG Edwards & Sons, Inc.Michael Bluhm

Alliance Commercial Partners, LLCRichard Stone

AMB Property CorporationLuis A. Belmonte

American Realty AdvisorsDuane C. HaleScott M. HolmesBrooks H. WellsBrian K. Wilson

Arden Realty, Inc.Howard Stern

AXA Financial, Inc.Michael Vitale

Bank of AmericaGary J. Katunas

Bank OneCharles B. Moffett

Bear, Stearns & Co., Inc.Thomas M. Flexner

Berwind Property GroupDaniel M. Dilella

BNP Residential Properties Trust, Inc.Phillip S. Payne

The Bonita Bay GroupDennis Gilkey

The Bozzuto GroupJohn Slidell

Bristol Group, Inc.James Curtis

Broadway PartnersSteven H. Klein

Buzz McCoy Associates, Inc.Bowen H. “Buzz” McCoy

Calistoga Ranch CompanyBrandyn Criswell

Capital Hospitality GroupCreighton Schneck

Capri Capital AdvisorsDaniel G. Goelz

Caprium Investment Partners, LLCMichael T. Butler

Carefree PartnersRichard B. West III

CarrAmerica Realty CorporationPhilip L. Hawkins

CB Richard Ellis, Inc.William C. Yowell III

CB Richard Ellis InvestorsJack A. Cuneo

Cencor UrbanThomas Terkel

CenterPoint Properties TrustJohn S. Gates, Jr.

Champion PartnersJeff Swope

Chesapeake Capital PartnersRobert Klainpaste

Citigroup Property InvestorsJoseph F. Azrack

Citistates GroupPeter Katz

CMD Realty InvestorsRichard Schaller

Cohen CapitalThomas Jaekel

Cohen & Steers Capital ManagementRobert Steers

Colony Capital, LLCRichard B. Saltzman

Column Financial, Inc.Kieran Quinn

Commercial Mortgage AlertPaul Florilla

Commercial Mortgage SecuritiesAssociationDorothy Cinningham

Contact Development CorporationBrett Ellsworth

Continental Development CorporationAlex Rose

Cornerstone Real Estate AdvisorsMarc Louargand

Coro Realty Advisors, LLCJohn Lundeen III

Corum Real Estate GroupV. Michael Komppa

Cousins PropertiesErling D. Speer

Credit Suisse First BostonAdam Raboy

Crescent Real Estate Equities, Inc.Jeanette I. Rice

Crescent Resources, LLCArthur Fields

Crosland, Inc.Todd W. Mansfield

Cushman & Wakefield, Inc.Timothy Welch

Deutsche Asset ManagementDonald A. King, Jr.

Industrial Properties CorporationGeorge A. Shafer

ING Real EstateWillard McIntoshJames Valente

Institutional Real Estate, Inc.Geoffrey Dohrmann

INVESCO Realty AdvisorsSteve Walker

The JBG CompaniesMichael Glosserman

The John Buck CompanyCharles R. Beaver

John Hancock Real Estate Finance, Inc.Jun Han

Jonathan Rose Co.Jonathan Rose

Jones Lang LaSalle, Inc.Bruce Ficke

JP Morgan Fleming Asset ManagementJoseph AzelbyBarbara BernardM. Douglas BissetNancy BrownDave EsrigMichael GilibertoEllie KerrFrederick Sheppard

Kansas Public Employees’ Retirement SystemRob Woodard

The Kevin F. Donohoe Co., Inc.Kevin F. Donohoe

Keystone Property TrustRobert Savage

Koelbel and CompanyBuz Koelbel, Jr.

Koll Bren Schreiber Realty AssociatesCharles Schreiber, Jr.


Donahue SchriberThomas L. Schriber

East West Partners–Western DivisionHarry Frampton

Eastdil RealtyJeffrey N. Weber

Ernst & YoungDale Anne Reiss

Faison EnterprisesAllen Jackson

First Fidelity Mortgage CorporationLance Patterson

First Industrial Realty TrustJames D. Carpenter

First Oxford CorporationThomas F. Kyhos

Fleetwood Enterprises, Inc.Roger Howsmon

Florida State Board of AdministrationDouglas W. Bennett

The Flynn CompanyDavid M. Ricci

Forest City EnterprisesJames A. Ratner

Fremont Realty CapitalSteven A. Karpf

Gables Residential TrustDavid Fitch

GE Real EstateMichael G. RowanDan Smith

General Growth PropertiesJohn Bucksbaum

General Investment and DevelopmentJeff Harris

Gilbane PropertiesRobert Gilbane

GLL PartnersDietmar Georg

GMAC Institutional AdvisorsRobert FabiszewskiKurt Wright

Goldman Sachs & CompanyBrahm S. CramerStuart M. Rothenberg

Green Courte Partners, LLCRandall Rowe

The Greenwich GroupR. Gary Barth

Grossman Company PropertiesG. Scott McCormack

Grubb & Ellis/The Winbury GroupTed A. Murray

Grubb Properties, Inc.Jeffrey W. Harris

Heitman LLCRichard KateleyMary K. LudginDavid Watkins

Henson-Williams Realty, Inc.E. Eddie Henson

Heritage Development Group, Inc.Henry J. Paparazzo

HIGroup LLCDouglas H. Cameron

HinesTom Owens

Holiday Fenoglio Fowler, LPMark D. Gibson

Horseshoe Bay Corp.Wayne Hurd

Hyde Street HoldingsPatricia R. Healy

IDIGreg Ryan


L. J. Melody & CompanyBrian Stoffers

Lachman AssociatesM. Leanne Lachman

Lake Las Vegas ResortW. Bradley Nelson

LaSalle BankDavid Maki

LaSalle Investment ManagementWilliam J. Maher

Lazard Freres Real Estate Investors, LLCRobert C. Larson

LCOR IncorporatedEric Eichler

Legacy Partners Commercial, Inc.Barry DiRaimondo

Legg Mason Wood Walker, Inc.Andrew C. Legros

Lehman BrothersMichael McNamaraRaymond C. Mikulich

LEM Mezzanine, LLPHerb Miller

Lennar PartnersPatrick S. Simons

Liberty Property TrustLaurie Brown

Lincoln AdvisoryGary Kobus

Lowe Enterprises CommunityDevelopmentJames DeFrancia

Lowe Enterprises, Inc.Michael LoweBrian Prinn

MacFarlane PartnersVictor B. MacFarlane

Majestic RealtyDavid Wheeler

Matrix Development GroupRichard F. X. Johnson

Max Capital Management CorporationMark L. Troen

Menlo Equities, LLCHenry D. Bullock

MeriStar Hospitality Corp.Bruce G. Wiles

Merrill LynchMartin J. Cicco

MetLife Real Estate InvestmentRichard McLemore

Mile High DevelopmentGeorge Thorn

Miller Brothers Investments, LLCKathleen Perkinson

Moody’s Investors ServiceMerrie S. Frankel

Morgan StanleyMark AlbertsonDave HardmanTed KlinckJay MantzJoe ThomasOwen D. Thomas

National Association of Real EstateInvestment TrustsSteven A. Wechsler

New Plan Excel Realty Trust, Inc.Glenn Rufrano

New York State Common Retirement FundMartin S. Levine

Newland CommunitiesW. Don Whyte

Nomura Securities InternationalSteven Bandolik

NorthMarq Capital, Inc.Jeffrey A. Chaney

Northwestern MutualMichael CusickDavid D. Clark

O’Connor Capital PartnersJohn Rivard

Ohio Public Employees Retirement SystemMary Beth Shanahan

Opus Properties, LLCWade Lau

Pacific Realty Associates, LPPeter F. Bechen

PacTrustDavid W. Ramus

The Palladium Group, Inc.Robert H. McKenzie-Smith

Pappas PropertiesPeter A. Pappas

Paradigm PropertiesStephen Allison

Pennrose PropertiesJohn Rosenthal

Pennsylvania Real Estate Investment TrustJonathan B. Weller

Pension Consulting AllianceNori Gerardo Lietz

The Peterson CompaniesJames W. Todd

Phoenix Life Insurance CompanyGerald W. Hayes

PNC Real Estate FinanceWilliam G. Lashbrook III


The Praedium Group, LLCRussell Appel

Prentiss PropertiesTom August

The Prescott Group, Inc.Susan L. Stupin

The Presidio Group, LLCH.P. Oliver

Principal Real Estate InvestorsRandy Mundt

Property & Portfolio Research, Inc.Susan Hudson-Wilson

Proterra Companies, Inc.Charles W. Akerlow

Prudential Mortgage Capital CompanyMichael B. Jameson

Quadrangle Development CorporationChristopher Gladstone

The Ratkovich CompanyWayne Ratkovich

The Real Estate RoundtableJeffrey D. DeBoer

Realpoint ResearchKim BetancourtJames Titus

Regency Centers CorporationMartin Stein

Regent PartnersDavid Allman

Regis Homes of Northern CaliforniaMark R. Kroll

RMB Realty, Inc.Thomas R. Delatour, Jr.

Robert Charles Lesser & Company, LLCGadi KaufmannGregg T. Logan

Rockwood Realty AssociatesMichael BreindelMark DeLilloJohn M. O’RourkeJason S. SpicerFrank J. SullivanR. John Wilcox II

Rosen ConsultingArthur Margon

RREEFMarvin Christensen

Russell Real Estate Advisors, Inc.Bruce A. Eidelson

Ryan Companies US, Inc.Daniel Levitt

Sabey CorporationJames Harmon

Sares-Regis GroupGeoffrey L. Stack

Secured Capital Corp.Christopher M. Casey

Seven Oaks CompanyRobert P. Voyles

The Shaw CompanyCharles Shaw

Shea PropertiesSteve Strambaugh

Shorenstein Company, LLCAndrew Friedman

Simon Property GroupSteve Sterrett

Sonnenblick-Eichner CompanyDavid N. Sonnenblick

Sonnenblick-Goldman CompanySteven A. KohnArthur Sonnenblick

Spectrum Realty Advisors, Inc.Jonathan D. Barry

St. Joe CompanyPeter S. Rummell

State of Michigan Retirement SystemBrian Liikala

Strategic Hotel Capital, Inc.David Sims

Studley, Inc.Michael J. Curran

Summit PropertiesSteven LeBlanc

Sunset Development Co.Alexander R. Mehran

Tennessee Consolidated Retirement SystemPeter L. Katseff

TerrabrookW. Stewart Gibbons

TIAA-CREFAlice M. Connell

Tishman Speyer PropertiesBrian D. Berry

TMG PartnersMichael CovarrubiasJ. David Martin

The Townsend GroupFrank Blaschka

Trammell Crow CompanyRichard Coe

Trammell Crow ResidentialMichael McGwierJ. Ronald Terwilliger

Transwestern Commercial ServicesSteven E. Pumper

Trinity Real Estate, Inc.Richard T. Leider

Trizec Properties, Inc.Timothy H. Callahan

UBS Global Asset ManagementLijian Chen

United PropertiesFrank Dutke

University of California at BerkeleyKenneth T. Rosen

Vantage Property Investors, LLCEdward (Ned) Fox

VEF Advisors, LLCJames Ryan

Ventana Properties, Inc.Joseph F. Martignetti, Jr.

Vestar Development Co.Lee T. Hanley

The Voit CompaniesDavid Allison

Vornado Realty TrustMichael D. Fascitelli

Wachovia Bank, NAMark Midkiff

Wall Street Realty Capital, Inc.Paul S. Saint-Pierre

Washington Real Estate Investment TrustThomas L. Regnell

Watermark Capital Partners, LLCMichael Medzigian

Watson Land CompanyBruce A. Choate

WCI Communities, Inc.Jack Train

Wells Fargo BankA. Larry Chapman

Wells Real Estate FundsDon MillerDavid Steinwedell

Westfield Capital PartnersRay D’Ardenne

Westfield Corporation, Inc.Peter F. KoenigRandall J. Smith

The Winter Group of Companies, Inc.Robert Silverman

The Woodmont CompanyStephanie Mower

Wynne/Jackson, Inc.Clyde C. Jackson, Jr.

York Properties, Inc.Smedes York


Joseph AzrackCitigroup Property InvestorsNew York, New York

John C. Cushman III Cushman & Wakefield, Inc.Los Angeles, California

Mark Eppli Marquette University College

of Business AdministrationMilwaukee, Wisconsin

Stephen J. Furnary ING Clarion PartnersNew York, New York

David GeltnerMIT Center for Real EstateDepartment of Urban Studies

and Planning Massachusetts Institute of TechnologyCambridge, Massachusetts

Jaques GordonLaSalle Investment ManagementChicago, Illinois

Joseph GyourkoThe Wharton Real Estate Center University of PennsylvaniaPhiladelphia, Pennsylvania

Susan Hudson-WilsonProperty & Portfolio ResearchBoston, Massachusetts

Mike MilesGuggenheim Real EstateWinchester, Massachusetts

James O’KeefeUBS Realty Investors, LLCHartford, Connecticut

Ken Rosen Fisher Center for Real Estate and

Urban Economics Haas School of BusinessUniversity of California at BerkeleyBerkeley, California

Richard B. Saltzman Colony Capital, LLCNew York, New York

C.F. SirmansUniversity of ConnecticutStorrs-Mansfield, Connecticut

James R. WebbJames J. Nance College of BusinessCleveland State UniversityCleveland, Ohio


Advisory Board for 2005


PricewaterhouseCoopers real estate group assists real estate investmentadvisers, REITs, public and private real estate investors, corporations,and real estate management funds in developing real estate strategies;evaluating acquisitions and dispositions; and appraising and valuingreal estate. Its global network of dedicated real estate professionalsenables it to assemble for its clients the most qualified and appropriateteam of specialists in the areas of capital markets, systems analysis andimplementation, research, accounting, and tax.

Real Estate Leadership TeamPatrick R. LeardoGlobal Real Estate Business Advisory ServicesNew York, New York646-471-2666

Robert K. Ruggles IIIReal Estate Valuation Advisory ServicesNew York, New York201-689-3101

Peter F. KorpaczReal Estate Business Advisory ServicesBaltimore, Maryland301-829-3770

www.pwc.com

Sponsoring OrganizationsULI–the Urban Land Institute is a nonprofit research and educationorganization that is supported by its members. Its mission is to provideresponsible leadership in the use of land in order to enhance the totalenvironment.

The Institute maintains a membership representing a broad spec-trum of interests and sponsors a wide variety of educational programsand forums to encourage an open exchange of ideas and sharing ofexperience. ULI initiates research that anticipates emerging land use trends and issues and proposes creative solutions based on thisresearch; provides advisory services; and publishes a wide variety ofmaterials to disseminate information on land use and development.

Established in 1936, the Institute today has more than 23,000members and associates from some 80 countries, representing the entire spectrum of the land use and development disciplines.Professionals represented include developers, builders, property own-ers, investors, architects, public officials, planners, real estate brokers,appraisers, attorneys, engineers, financiers, academics, students, andlibrarians. ULI relies heavily on the experience of its members. It isthrough member involvement and information resources that ULI hasbeen able to set standards of excellence in development practice. TheInstitute is recognized internationally as one of America’s most respect-ed and widely quoted sources of objective information on urban plan-ning, growth, and development.

Senior ExecutivesRichard M. RosanPresident

Cheryl CumminsChief Operating Officer

Rachelle L. LevittExecutive Vice President, Policy and Practice

ULI–the Urban Land Institute1025 Thomas Jefferson Street, N.W.Suite 500 WestWashington, D.C. 20007202-624-7000www.uli.org


Emerging Trends in Real Estate® 2005What are the best bets for development in 2005? Based onpersonal interviews and surveys from more than 500 of themost influential leaders in the real estate industry, this forecastwill give you the heads-up on where to invest, what to develop,which markets are hot, and how the economy, social andpolitical issues, and trends in capital flows will affect realestate. A joint undertaking of PricewaterhouseCoopers and theUrban Land Institute, this 26th edition of Emerging Trends isthe forecast you can count on for no-nonsense, expert advice.

Highlights

■ Tells you what to expect and where the best opportunities are.

■ Describes trends in the capital markets, including sources andflows of equity and debt.

■ Advises you on those metropolitan areas that offer the mostpotential.

■ Tells you which property sectors offer opportunities and whichones you should avoid.

■ Provides rankings and assessments of a variety of specialtyproperty types.

■ Reports on how the economy and concerns about job growthare affecting real estate.

■ Describes the impact of social and political trends for real estate.

■ Explains how locational preferences are changing.


www.pwc.comwww.uli.org

ULI Order Number: E21

ISBN: 0-87420-934-X