Focus for '06: Profiting in a New Environment

[ By Ellen Rand and Ron Derven ]

After a full day of educational sessions, attendees network and enjoy the beautiful Florida scenery.

A hurricane may have been brewing in the distance during NAIOP's recent Annual Conference at the Westin Diplomat in Hollywood, Florida, but indoors - despite looming questions about interest rates, cap rates, energy and construction costs and the not-quite-yet-full-bodied office market recovery - the skies were cloudless. To be sure, change was in the air: a shift away from conventional suburban office development and toward infill and mixed-use development (urban and suburban); a growing curiosity about global opportunities; and an increasing awareness that demographic and logistics trends could soon render previously unsung markets newly ready for their close-ups.

Speakers grappled with the issue of whether or not the flood of capital flowing to real estate - and the nosebleed pricing and low yield expectations that go with it - are the "new normal," but did not raise any alarm bells. With real estate fully ensconced as a desirable asset class, attendees were attentive to finding ways to exploit emerging opportunities in alternative development.

In a general session on "Successes and Lessons Learned," featuring past Developers of the Year Boyd Stofer, president and CEO of United Properties, LLC, Robert J. Lowe, chairman and CEO of Lowe Enterprises and Terry W. Stiles, chairman and CEO of Stiles Corp., moderator James M. (Marty) Irving posed a number of questions that echoed attendees' concerns: in short, how do we continue to thrive long-term in an ever-changing environment?

Discussing the question of whether or not to remain a private company or go public, Bob Lowe pointed out that there are "two reasons to go public: you need capital, or you want to capitalize on the enterprise. We have always been able to access the capital markets and we're in this for the long term. We are more interested in building a company for the future. So there is no reason to go public."

Stiles noted that in 1991, when the question of becoming a REIT came up, his partner Wayne Huizinga advised, "You don't want to live in a glass house" and indeed Stiles has remained a private company.

The industry leaders were cautious and strategic about entering new markets. As Boyd Stofer explained, "We're looking at Denver now, but just for retail, which is more easily transferable. To go in and do office or industrial development would just be fantasy."

Bob Lowe said that his company's geographic diversity varies by product type. In major office markets, he said, "it began because established long-term relationships brought us in with an opportunity. In resort development, we identify the markets we want to be in."

Lowe's hospitality business is active in a dozen states, office in a half-dozen and resort in a half-dozen. Stiles Corp., on the other hand, made the decision two years ago to stay in South Florida. After trying to diversify in Atlanta and, later, Nashville, Stiles said, "we learned we can't transport our culture." He also explained that the company is currently working on complex mixed-use and redevelopment deals, and "It's a lot better to have a closer view," he said.

Regardless of geographic involvement, these developers' eyes are clearly focused on the future. And that future includes plenty of infill and mixed-use development, both urban and suburban. As Boyd Stofer remarked, "Mixed-use is here to stay. We're on a steep learning curve - I love it; it's a wonderful change."

Stiles concurred that because that learning curve looms so large, "We still lean on outside expertise for marketing. Bringing [different] together is the biggest challenge. We're wrestling with that. It's a whole new set of challenges."

In a general session on "Successes and Lessons Learned," featuring past Developers of the Year Boyd Stofer, United Properties, LLC, Terry Stiles, Stiles Corp., and Robert Lowe, Lowe Enterprises, moderator Marty Irving, Irving Interests, taps the expertise of these industry greats.

Steep construction costs are a concern for the near future. Stofer said, "The cost of construction is what it is. Ultimately the market has to adjust to the cost of delivering the product." He also observed that mixed-use development presents a different challenge because of the length of time involved in these projects - which means that different market conditions might prevail when different types of uses are complete. With the likelihood that "payday comes at the end of the rainbow," he said, "you need staying power, vision and the capital structure underneath you" to weather different market cycles.

Lowe said that of five projects his company is working on in different markets, construction bids came in 30 percent higher than the year before. How to manage? "You do value engineering, redesign, do the best to get costs back in line," he said.

Stiles noted that some contractors are offering adjustable contracts, but "that doesn't do an owner a bit of good. You can't charge adjustable rents." He said that he is also fearful of a "cost bubble" - of locking in higher construction costs, when there is a possibility costs will decline in a year. "It will be a real tough 12 months, to figure it out," he said.

The developers are also focused on the future of their companies. Boyd Stofer observed that before embarking on a succession plan, "You have to decide what kind of company you are; what's the reason for your existence?" In the '90s, for example, the decision was made that United Properties should be an operating company that can be sustained through good times and bad. This has enabled the company to "develop a deeper culture of talented people. It builds the next generation of leaders. I'm not worried about it at all," he said. Stiles said that "Our new term is building a 100-year-old company," adding that "Succession is important for the heirs as well as the guys who've given their whole lives to the company. We are actively in the succession planning business."

Lowe pointed out that the company has worked hard over the past several decades to create predictable revenue; that sustainability is important to the company; and that it is focused on building around a committed, team-oriented and entrepreneurially skilled management team.

"We are a values-oriented firm," he said. "We are highly ethical in how we treat [people] inside and outside the firm." Currently, he noted, the company is in the process of "transitioning from the management team that built the company with me. A younger management team is moving into positions of leadership." In the meantime, the burning question of the day remains, how much longer will the low cap rate environment persist? Are high prices and low yield expectations secular or cyclical phenomena?

Stofer said that "Real estate has become a more acceptable product type. What's the risk premium people are going to require going forward? Today it looks like a bond with a kicker."

Lowe sees the current climate as both secular and cyclical, secular owing in part to a series of long-term trends, including demographics ("this world is not going to get younger in Western countries"). It is still cyclical, in that different markets and different product types will still experience cyclical changes.

Whither the Economy and Markets in 2006?
Recovery, Expansion, Hypersupply and Recession: these are the real estate market cycles of our lives. Where are we now? Prof. Glenn Mueller, director of the Colorado State University Center for Real Estate and a real estate investment strategist for Legg Mason Wood Walker, explained that nationally, office real estate is in position #2 in Phase I Recovery, finally moving off the bottom of the occupancy cycle in the second quarter of the year. Industrial, also in position #2, posted occupancy improvement of 20 to 30 basis points, which translates to an expected one percent occupancy growth and one percent rent growth in 2005.

Making the Business Case for Sustainable Development are moderator Douglas Howe, Touchstone Corp. and panelists Rebecca L. Flora, Green Building Alliance; Joseph McNeill III, CalPERS; and James V. Maneri, Liberty Property Trust.

Of course, conference attendees were more focused on looking ahead, not back, and Prof. Mueller voiced what had to be on the minds of many: "Employment growth determines demand - when does it come back?"

He predicted that national average occupancy rates will still be in position #2 by mid-2006, with rent growth of two percent by the end of this year and three percent in 2006. "The market will return to a growth phase for industrial property in 2006 and in 2007-2008 for office," he said.

Hessam Nadji, director and chief marketing officer, Marcus & Millichap, Walnut Creek, California, told conference attendees that "From our vantage point, the economy is doing great. It is in good shape even after the energy price shock and hurricanes. Total employment in the West, since the trough of the last cycle, is up by 4.2 million jobs. We only lost 2.7 million jobs during the downturn. So not only have we regained all the jobs we lost, we are also well ahead of where we were during the last peak. It doesn't feel like that just because we never had a big pop after the recession."

Oil prices and interest rates will create a natural break for the economy, Nadji predicted, observing, "That is okay for a while. The price pressures are beginning to trickle into the consumer and business sector -- business costs are going up because of raw materials. If we basically sustain energy prices around where they are today, which I think we probably will, we will see more than a slowdown in the economy due to the drain out of consumer and business expenditures. But we are not anticipating any type of hyperinflation. Slowly but surely inflation pressures are building and there is nowhere for inflation to go but up. We think we will have about a three percent core inflation rate, but it does create pressure on interest rates."

Housing is a huge pillar of the economy, he noted, accounting for 20 to 25 percent of economic growth since 2002. The housing market is beginning to show some cracks, especially with adjustable mortgage rates rising. He cautioned that there will be a slowdown - though not a major crack -- in housing.

"To me demographics are everything," he said. "Baby Boomers and emerging Echo Boomers represent a huge market. This phenomenon really explains the underlying force of the housing and retail market, which is driving more than two-thirds of U.S. economic activity. Baby Boomers are 76 million strong and Echo Boomers are about 70 million strong. So when you put that demographic weight together with the recent employment outlook, that's where we get our optimistic outlook."

Where Opportunities May Be Knocking
At a seminar on "Opportunities in Alternative Development," developers made a strong case for three alternatives: senior housing, medical office and education facilities. John Gorecki, senior vice president-senior housing, The Daniel Corporation, Birmingham, Alabama, noted that the retirement housing market is strong and growing. "It is large, it is growing, it is affluent, it is stable, and it is here to stay," he said. "There are three generations of seniors that are at retirement age or are ready to be at retirement age. Between 1996 and 2010, the number of adults over age 65 will increase by six million people. By 2060 there will be almost 80 million people 65 years of age or older. Over two-thirds of the people who have ever turned 65 in the history of the world are still alive. By 2050, there will be 17.7 million people who are 85 years of age or older.

After highlighting the association's achievements over the past year, 2005 Chairman Joseph Taylor, Matrix Development Group, welcomes 2006 Chairman Robert Cutlip, Highwoods Properties Inc.

"Regarding the concentration of wealth: Seniors account for 77 percent of all financial assets, 48 percent of all luxury cars and 40 percent of total consumer demand," he said.

Sharon Harper, president, The Plaza Company, Peoria, Arizona, explained that there has been a big shift in the way medical office development is brought to market. "For many years the almost exclusive area for medical office development was on hospital campuses or in plain, very practical buildings," she told the NAIOP gathering. "There was little interest in architecturally significant projects. Rarely did physician-tenants demand highly visible or highly accessible 'A' locations. The brokerage community was not particularly involved and patients were expected to wait for services.

"However, the business has changed significantly," she went on. "Reimbursables for physical services, which have driven the business, are down. Patients now have a higher level of expectation. They want a more businesslike treatment, waiting areas, less wait time and convenient referral services. Physicians, because they are making less money, want opportunities to invest in real estate and be part of what they are leasing to supplement income. Healthcare facilities now want good locations, convenience."

Audience participation makes for the interactive flavor of the conference. Here Rick Collins, Ryan Companies USA, poses a question to a speaker.

She said that hospitals are changing as well. They are focusing on trying to do their business well because it has become highly competitive and reimbursables are significantly different. Business is leaving hospitals and going to outpatient settings.

A third option for alternative development is education facilities, according to Gary Paetau, senior vice president, educational real estate services, Carter, Atlanta, Georgia. (See Paetau's article on page 46 of this issue.)

"Based on the last information I have seen, over the next seven to eight years there will be a need for some $2 trillion on college campuses to meet the demands that are out there," said Paetau. "For most institutions, that is daunting. They do not have the funding capabilities to meet the requirements that are pressing on them right now. So they are looking to a number of different entities and partners to form public-private partnerships and you will see more and more of it every day."