New Opportunities to Explore in '05, With Yet More Capital Flowing to Real Estate

[ By Ellen Rand and Ron Derven ]

Left to right: Hank Brenner, John Hurley, Don Chase.

Property owners of the world, invest! You have nothing to lose but your old assumptions about value and yields.

That was the message, loud and clear, that attendees heard at NAIOP's recent Annual Conference and Marketplace in San Diego. Economists, analysts and capital markets experts predicted not only that the tsunami of capital will continue to flow to real estate from public and private sources, but also that cap rates are likely to remain low and yield expectations modest for the foreseeable future.

At the same time, the need (not to mention economic feasibility) of new office and industrial development is dwindling, so developers must look for new opportunities in alternative property categories - including urban mixed-use, healthcare and biotech - and there were numerous sessions devoted to just those opportunities. Generally, the speakers; and attendees' mood was upbeat, with a palpable sense of "the worst is over" - that is, sublease and "shadow" space no longer loom large; the economy has shown measurable improvement; and absorption has improved in many markets. As John C. Cushman III, chairman of the board of Cushman & Wakefield, pointed out in a session on "Strategies for Success in 2005," while only one out of 32 CBDs had positive absorption (that was Washington, DC) in 2002, 21 are expected to have positive absorption this year.

Consider the observations of Sam Zell. With 128 million square feet of office space, 225,000 apartments and 40 years in the trenches under his belt, Zell's words carry unusual weight. As keynote speaker at the Chairman's Breakfast, on the subject of "How to Profit from Opportunity," Zell, chairman of Equity Office, Chicago, Illinois, told attendees that both the U.S. economy and the various real estate markets are sound and should get better in time.

Still, he said, "We are dealing with a pretty mature economy. I don't see a stoppage of development, but it is not the leading edge it used to be." Regarding the real estate industry, he noted, -I think we are in kind of a sweet spot. The fundamentals in all areas of real estate are improving. Whether it be apartment, office, industrial or hotel, occupancy is improving across the board. At the same time that our business is improving, however, there is a gap between replacement costs and what current rents will justify that has dramatically widened over the last 18 months.

"I believe today that gap is where it was in 1993," he went on. "We need to get 30 to 40 percent increased rents to justify new construction. As you know, facts have never imperiled the development community. But I think it is important to understand how different the real estate world is today than it was 15 or 20 years ago. The level of transparency is extraordinary. I think we will see [fewer] excesses in the future than in the past."

Roundtable discussions were as popular as ever, offering moderators and attendees an opportunity to share information and insights in an informal setting.

Regarding the economy, he observed that:

• The U.S. economy is progressively getting better. Despite all the comments on the jobless recovery, as recently as 10 years ago, structural unemployment was 5.6 percent - the current unemployment rate is 5.4 percent.
• The issue of finding employees in the future is a lot bigger than the question of unemployment levels of today - and the "graying" population will raise stark issues in the future.
• Interest rates are historically low. Zell said that many people view the 2000 recession as just another recession. The reality is that "we came through a bubble that was every bit as speculative and every bit as dangerous as 1929. The steps that our government took - reducing interest rates to historic lows, tax cuts and various other steps - were necessary and critical," he contended.
• We have now overcome the risk of deflation from the risk of massive speculation of the late 1990s.

  2003 NAIOP Chairman Dan DeMarco (left) congratulates outgoing Chairman Steve Crosby on an outstanding year for the association.

• The CPI has been benign over the last three to four years because 42 percent of the CPI is something called the "rent equivalent" and specifically refers to rental rates and multi-family housing. "Anybody who built a building in the last year and had to buy steel, aluminum or cement had a hard time believing that we are dealing with one or one-and-a-half or two percent inflation," Zell commented.
• The U.S. has a $500 billion a year deficit: "I believe that deficit was necessary but it is an issue that we will all have to deal with going forward, no matter who is elected president," he said.
• At the same time, the reversal of the tax cuts would be very negative for the growth of the economy. Zell views the economy as still very fragile, with the remnants of the late 1990s still being worked off.
• The trade deficit may worry pundits, but Zell is not in that camp. "My own view is that the trade deficit is not anywhere near as dangerous as many people suggest," he said. "I think the overall U.S. economy is in very good shape. I think we will see continued growth and I think we will continue to see the U.S. lead the rest of the world economically. Perpetuation of our unique culture is what the future is all about."

Modest Expectations for '05

Sam Zell, keynote speaker at the Chairman's Breakfast, told attendees that "We are in a kind of sweet spot. The fundamentals in all areas of real estate are improving.

Dr. Norman Miller, director of the Real Estate Center of the University of Cincinnati and a NAIOP Fellow, pointed out, at a session on Financial Feasibility and Risk Analysis, "What would happen if pension funds and mutual funds increased their [real estate] allocation from 3.5 percent to 6, 8 or 10 percent" One percent of this is $100 billion, equal to 70 percent of the total REIT equity market. Yield requirements have gone down and cap rates have gone down by 100 to 200 basis points. An increase in inflation and interest rates could reverse this - but there's not enough real estate to go around."

With that as a backdrop, speaking at a session on "Investment Strategies, Risks and Opportunities," Hessam Nadji, managing director and chief marketing officer for Marcus & Millichap in Walnut Creek, California, noted that employment growth has lagged behind a broad economic recovery, in part because of productivity. For every one- point increase in productivity, he declared, the economy needs 1.3 million fewer jobs.

"Companies don't need to hire," he said. Moreover, we are now experiencing "a third wave of uncertainty; every six months the drivers of uncertainty change. Once we work through those, we should see some spark in the economy." On the other hand, he said, we lose a half-point of GDP for every $10 increase in the price of oil.

"Retail is the only property type that has posted increases in net operating income," he said. Yet, as low as real estate returns are, they are still higher than what investors can find in the bond market, and at least for the moment, less volatile than the stock market. Hence, the huge and growing investor appetite for real estate. For 2005, Nadji sees:

• No systemic pricing bubble.
• Buyer demand for real estate rising, with intensifying competition among capital sources.
• There will be a "catch-up" period between pricing and fundamentals, when the economy and capital markets "normalize."
• Capital will shift in favor of office and industrial investments.
• Investor hurdle rates will continue to decline.
• Lower yields will remain the trend; there will be no reversion to higher yields for at least three years.
• The real estate operational recovery will be mild. He observed that the current investment climate might be "tougher for more astute investors," who have been waiting patiently on the sidelines until some correction happened, but he stressed that they "may be missing out on the next wave, because conditions aren't going to change in the near future. They're not facing reality."

That said, he advised investors to:

• Look beyond the first two years of a pro forma and substantially adjust downward rents in buildings with lease rollovers coming.
• Underwrite your lease rollover strategy, without assuming three percent rent growth and a reversion to traditional cap rates.
• Understand that more value has to come from operational improvements and property positioning.
• Value-added investments are alive and well; they're just not discounted.
• This is an ideal time for portfolio and market profile upgrading.
• Take advantage of the capital markets now, because current conditions will not last forever.
• Understand that although real estate is still a profoundly local business, both macro and micro factors are equally critical in analyzing potential acquisitions.

A Race Between Job Growth and Debt Crisis

"Price support for real estate is solid," Susan Hudson-Wilson of Property & Portfolio Research told Conference attendees.

The consumer is a big concern, in Hudson-Wilson's view. Consumer spending accounts for two-thirds of the GDP and it has been a "miracle" that such spending has propped up the economy as it has. "But we may be at the end of that line," she said, particularly with gas at $55 a barrel. "This is a problem. It's a tax that comes right out of your pockets and goes to the Middle East."

And while business and government are not putting pressure on interest rates, household debt - which represents half of the total debt - is 22 percent above average, which translates into a tremendous risk. In the meantime, while there has been job growth, it has not been sufficient to absorb new entrants to the labor force.

"Rates of job growth vary widely, depending on where you are," she said, noting that Las Vegas; Washington, DC; Phoenix; and St. Louis are big winners. Detroit; Hartford; Indianapolis; New Orleans; Pittsburgh; Cleveland; Columbus; Philadelphia; Boston and San Jose are big losers, and "all but Boston and San Jose fall into the category of sadness. In America, when we're done with a city, we leave it. There are no barriers like language, currency or jobs. We just get up and go."Nevertheless, she said, "Price support for real estate is solid. Real estate debt is low, low, low." Pension funds have been "late to the party," she said, waiting (as have so many seasoned developers and owners) for the "disaster that wasn't going to happen."

And there's more money coming: Australian, German and Middle Eastern investors have already made a mark in the U.S. market. Still to come, she said, are the Japanese (they have a $5 trillion postal savings system that needs reform, she said). Moreover, Fidelity is planning to open up a private, no-load fund for small real estate investors, with an eye on low-risk investments.

She predicted that real estate performance will be excellent on a relative basis, "which is all that counts," and that office and industrial will outperform the market over the next four years. For industrial properties, she said, "We're looking at a fabulous, exciting recovery."

From 1982 to 1992, 180 million square feet of office space needed to be built. Hudson-Wilson projected that we will need between 50 to 60 million square feet between 2006 and 2020. Of particular note is that baby boomers will start to retire in 2008; that could impact overall demand for office space with the smaller Generation X taking their place. "The risk is going to be back on the supply side," she warned, adding that "the planning line is getting kind of shocking," with new planned office development up 80 percent, retail up 80 percent, industrial up 47 percent and hotel up 73 percent. "There is no such thing as spontaneous creation. Anyone who gets caught in an excess supply situation is stupid. You can track supply monthly.

"Inflation is already here for commercial real estate," she went on. "Replacement cost growth has increased 10 percent year after year. The silver lining is that as costs rise, new construction doesn't pencil out so well. Scarcity is a valuable idea. There is tremendous financial support for existing assets."

For more information

Annual Conference presentations,
go to www.naiop.org.

Sustainable Industries That Will Drive Demand Futurist David Pearce Snyder outlined how certain industries are expected to grow between now and 2012. So where will demand come from? David Pearce Snyder, consulting futurist, The Snyder Family Enterprise, Bethesda, Maryland, predicted that big changes afoot in the American workplace will impact office and industrial properties between now and 2012. He cited the following: Education - The nearly 2.5 million new jobs created in Education between 2002 and 2012 will be spread across three types of employers. Roughly half will be in public and private K -12 schools. One-fourth will be in post-secondary education (two- and four-year colleges and universities). The final one-quarter of expansion hiring for education will largely consist of employee training and vocational, technical and career education, including trade schools and apprenticeship programs. Health and Medical - Three different classes of health-related enterprise - Ambulatory Healthcare, Nursing and Residential Care, and Hospitals - will combine to generate 20 percent of all new U.S. jobs between 2002 and 2012. Professional/Scientific/Technical - Over half of the 1.9 million new jobs created in Professional, Scientific and Technical Services will be concentrated in two components of that sector: "Computer Systems Design" (635,000 new positions) and "Management, Scientific and Technical Consulting Services" (406,000 new positions). The remaining 857,000 jobs generated in this sector will be evenly divided between traditional professions like law firms and CPAs and "specialized design, scientific research and other professional/technical services." Employment Services - The dramatic expansion of the Employment Services industry reflects the rapid growth of firms like Manpower, Inc., Kelly and Express Personnel and the rise of temporary employment throughout the U.S. workplace. Transportation and Warehousing - Employment in Transportation and Warehousing rose 21.5 percent from 1992 to 2002 and is projected to grow an additional 21.7 percent between 2002 and 2012, 50 percent faster than the overall growth in U.S. employment. This sustained expansion is the combined result of continued increases in exports and imports, the steady growth of on-line retailing and the outsourcing movement - which is leading formerly self-sufficient, "vertically integrated" enterprises to contract out an increasing share of their in-house operations to both domestic and foreign suppliers. The orchestration of complex inter-city/international supply chains has turned old "shipping departments" into "Logistics Management Divisions." While the "Trucking" component of the sector will experience the largest increase in employment (275,000), the "Warehousing and Storage" component is expected to see the fastest growth (28.6 percent), adding 147,000 jobs between 2002 and 2012.