Investing in Real Estate
Real estate markets should be well-positioned to weather a possible recession this year, according to the latest emerging trends forecast

Having entered a period of relative supply/demand balance, the nation's real estate markets are reasonably well-positioned to weather a potential economic recession this year, according to Emerging Trends in Real Estate: 1999, an annual industry forecast by Lend Lease Real Estate Investments and PricewaterhouseCoopers. The report, recognized as one of the longest-running and most predictive industry forecasts, is based on in-depth interviews and surveys with more than 150 real estate investors, developers, analysts and space users.

The report includes the following predictions:

• REIT performance should rebound modestly this year after being hammered in 1998. Investors should expect "bond plus" returns. These stocks should throw off solid yields and trade at prices more aligned to their underlying value. "REIT pricing got way ahead of the private markets in the 1995-1997 period" the study reports, and "ran out of gas when investors realized the high-flying growth strategies weren't in sync with leveling off market fundamentals."

• The CMBS markets are here to stay despite the recent pummeling of issuers and bond traders attributable to last fall's credit crunch. "Fundamentally growth should continue," the report notes, but investors should anticipate consolidation among conduits down to "about 10 recognized players committed to the business." Defaults and delinquency rates of mortgages, meanwhile, are nearing 20-year lows. There's been a "disconnect" between the financial markets and underlying real estate fundamentals.

• Core real estate investors in the private markets should have a solid year, if portfolio managers took advantage of recent rent spikes in advancing markets and locked in credit tenants on new leases. Under any circumstances, investors need to adjust expectations downward after five years of strong returns in the real estate markets and an unprecedented run for stock investors. "Investors need to get their heads straightened out if they think the stock market will pump up returns at a 20 percent clip for the indefinite future and then also expect matching performance from real estate," the report notes.

• The supply side is under control as aggregate commercial construction has remained below the average of the past 15 years. Only the hotel sector shows signs of overbuilding, primarily in the limited service sector. A potential economic downturn could reduce tenant demand and soften markets. But strong overall occupancies in office, industrial and apartment categories offer some cushion. In a recession, the most vulnerable property sectors would be hotel and retail. The lodging sector is traditionally most vulnerable to recessionary tides, as business and tourist travel can immediately show up in declining occupancies and lowering room rates. But industry cost-cutters have reduced break-even occupancies to about 55 percent (from about 64 percent 10 years ago), providing some downside protection. Performance of retail properties has lagged even in the strong economy of the past five years. If consumer spending declines, cash flows from shopping centers will slow.

• Investors still favor 24-hour cities over suburban agglomeration metropolitan areas. San Francisco, Seattle, Boston, New York and Chicago lead the survey for best investment prospects this year. All have solid occupancies with limited near-term development underway. West Coast Pacific gateways are vulnerable to the Asian flu. East Coast financial markets -- particularly New York and Boston -- could be hurt by layoffs in Wall Street-related businesses. Sunbelt markets like Atlanta, Dallas, Phoenix, Houston and Denver rank lower, because of perceived higher development risk. Demographic factors -- aging baby boomers and career-minded Generation Xers -- also favor cities for the near term as they offer more convenient lifestyles for empty nesters and more excitement for post-graduates. Although more Americans live in the suburbs today, congestion and infrastructure issues pose serious problems for some suburban markets. But 24-hour cities have not overcome the triple threat of concentrated poverty, shrinking populations and middle-class flight. Urban schools systems offer dismal achievement records, a big negative.

• Downtown office and industrial warehouses are pegged as the best investments for 1999 among property sectors. Performance is expected to cool for suburban office and full service hotels. But these sectors should plateau rather than show significant drop-offs. Limited service hotels could face major declines. Retail will continue to trail other sectors. Only the country's top 200 "fortress regional malls" and well-located community centers are favorably positioned.

"Clearly, how world financial markets will impact the U.S. economy is a huge unknown today," explains Matthew Banks, CEO of Lend Lease Real Estate Investments. "But U.S. real estate markets are somewhat insulated. If the economy holds up, real estate investors will have a solid, although unspectacular year. If a recession takes root, real estate offers a relatively safe harbor."

Source: Lend Lease Real Estate Investments and Pricewaterhouse Coopers

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