1999 Year in review: A tale of commercial real estate

It was the best of times, and it was the worst of times for the real estate industry in 1999. The office market flourished, while the retail component had a dickens of a time getting a handle on e-commerce. The industrial sector was hot, but hotels were not so hot. Multifamily developers built projects as if there was no tomorrow. In the senior living sector - which had experienced a construction spree over the past several years - reality set in, and developers faced an oversupply of properties in some areas. In addition, real estate investment trusts (REITs), which could do no wrong even two years ago, failed to do nearly anything right in the 12-month period.

Still, despite a few blips on the screen, 1999 was a spectacular year for commercial real estate, says Stephen B. Siegel, the chairman and CEO of New York-based Insignia/ESG Inc.

"After the late 1998 capital markets collapse, the year started off very slowly - a product of what I believe was a rollover of the capital markets collapse," says Siegel. "People were sitting back to see how bad it was. But midway through the first quarter, the leasing and sales velocity picked up, building momentum in the third and fourth quarter."

Because of solid economic fundamentals - 3% general growth, low to no inflation and good corporate profits - the real estate market performed well last year. "That added up to solid markets, positive absorption, rent growth and solid sales," says Siegel.

Rob Carter, a partner at Charlotte, N.C.-based Berkeley Capital Advisors, agrees. "A lot of capital remained in the market and continued that way throughout most of the year," explains Carter. "Some said the lack of capital that resulted from REITs getting out of the markets was countered by pension funds doing deals and joint ventures. Pension funds were very active in 1999 in the acquisition of properties in core markets."

Office: cautious optimism During the year, office vacancy rates continued to fall in most major cities, according to brokers, while rents and property prices kept inching up. More importantly, after nearly eight years of relatively booming times, no hints of an imminent bust appeared on the horizon. Some 285 million sq. ft. of office space was under construction in 1999, compared with some 350 million sq. ft. at the peak of the real estate cycle in 1985.

Jerry Barag, chief investment officer of Atlanta-based Lend Lease Real Estate Investments Inc., says 1999 was a good year for owners. "Generally if you started out in 1999 owning properties and got to the end of the year to sell them, you did pretty well," he says. "We saw good fundamentals. Supply and demand held up pretty well, although in some markets, construction got ahead of itself. But we still saw healthy leasing activity in those markets. Because lenders and others perceived problems coming down the track, construction stopped."

During the year, the real estate industry found rents continuing to increase - although not as fast as they had in years past. However, the sector did not experience the overbuilding that had occurred in the past, says Ray Milnes, national industry director/real estate for New York-based KPMG LLP. "Lenders were doing a good job of putting a governor on the throttle," he says. "Lenders were looking for more preleasing. We didn't see a lot of excess product coming on the market. With a strong economy, absorption remained good, and the real estate market was fairly well balanced."

Milnes notes that investors continued to show an interest in investing in Europe and elsewhere. There were more opportunistic funds, including some REITs that were looking to buy not only on the continent but in the Far East as well. However, REITs continued to be befuddled by what was happening in the marketplace, he adds. "Although they showed strong results, there was a lot of head scratching about 'what do we need to do to endear the capital markets?'" says Milnes. "Institutional investors, pension funds and opportunistic funds got back into the market and acquired some trophy properties without much competition."

For instance, German investors took up the slack from the REITs, snapping up One Liberty Place, the tallest building in Philadelphia for some $250 million. Manhattan's biggest deal of the year was the $560 million German syndicator Jamestown paid for the 1211 Sixth Avenue building. Among the hottest office markets: New York and San Francisco. In New York, for example, returns are the highest in a decade, analysts say.

Globally, the past year had all the makings of a morality tale - one that punished the once-mighty and gave renewed market power to the humble, says Jacques N. Gordon, international director for investment research and strategy at Chicago-based Jones Lang LaSalle Inc.

"Capital flows were down 40% from the previous year as the highly-leveraged, speculative construction frenzy of the first and second quarters of 1998 tailed off in the wake of a global capital market crisis," says Gordon. "But, as 1999 showed, this was the best thing that could ever have happened to real estate. There are still plenty of skeptics who believe that the real estate capital markets are genetically programmed to go through boom and bust. This was a chance for the real estate markets to show some discipline and backbone."

The commercial real estate markets backed off just as a modest threat of overbuilding came into view, he continues. "In 1999 there was still plenty of equity in the market, but now it was being handled by conservative pension funds and German fund buyers, not the once high-flying REITs or highly-leveraged individual buyers," says Gordon. "REITs were actually net sellers of real estate, but the smartest REIT managers still had access to capital."

During 1999, investors were reminded that, when markets are in equilibrium, real estate plays a stabilizing role in a portfolio. "Real estate's lower volatility, relative to technology stocks, may have been overlooked by aggressive growth investors last year," says Gordon. "But, patient capital with a longer investment horizon continued to move a lot of money into income-producing buildings in 1999," he adds.

Chicago reported a strong year for absorption and gross leasing, says Richard M. Gatto, executive vice president of The Alter Group, Chicago. "At the beginning of 1999, there were a number of new construction projects and new offices under way, but caution still loomed in the market," says Gatto. "Still, it is clear that markets like the Chicago area are strong."

The real key to the health of the real estate industry in 1999 - and continuing this year - was corporate earnings growth. "It's reallythe Fortune 100 companies, the high-techs and the Internet software companies that are driving the stock market and the real estate market as well," says Gatto. "It's really a question of how well those firms continue to grow and do. If they do well, it's going to be a good year. If they stop and level off and stop taking space, the industry is going to slow down."

In 1999, the real estate investment market was generally in equilibrium, adds Glenn Lowenstein, senior vice president of Houston-based Hines. "Plenty of buildings were for sale, and even though the REITs were not very active, the private capital market was still very active," he says. "Foreign investors are also increasing their activity. Because several property types, including office, have stopped new construction short of oversupply, the general investing climate is benign with prices generally hovering around replacement costs."

At the same time, 1999 also saw an increase in corporate outsourcing, says Diane Tucker, senior managing director of national accounts at Dallas-based Trammell Crow Co.

"Our institutional customers were really looking at alliance relationships with a service provider," says Tucker. "More companies wanted to deal with a dedicated team for their real estate needs. If they wanted to make a change in the lease form they wanted to call one person, not 50."

Retail gets a grip In 1999, fortune smiled on the nation's retail industry, which experienced strong holiday sales, a lessening of the e-commerce threat and less consolidation in the industry.

Even after nine years of economic expansion and retail spending, the sector continued to perform well, says Joe Edens, chairman and CEO of Columbia, S.C.-based Edens & Avant. "I think the retail real estate property sector is as fundamentally sound as I've ever seen it," says Edens. "I think one of the real highlights of 1999 was the sales trends that occurred and how the industry got through the big Christmas season without being negatively affected by e-commerce or a loss of consumer confidence."

He adds that 1999 revealed a clearer picture about how the Internet was going to be used and how e-commerce would impact the retail industry. "A lot of unknowns became known, and the fear that existed, resulting in retail properties falling out of favor, started to dissipate somewhat," says Edens.

Drew Alexander, president of Houston-based Weingarten Realty Investors, points out that the strong economy benefited the retail sector. "By most accounts, it was a good [year] for sales, which were up 5% to 7%," says Alexander. "More importantly, from everything I've heard anecdotally, margins and profits should be good also. Of course, there were discrepancies between the haves and have nots. The good retail performers continued to perform fairly well, while some of the companies still working to reinvent themselves had a harder time."

Alexander, a past chairman of the International Council of Shopping Centers (ICSC), adds that the dark cloud that hung over the retail real estate industry for most of the year - e-commerce - dissipated toward the end of the year. Industry analysts and the media had predicted Internet retailing would have an adverse effect on the traditional "bricks-and-sticks" retailers, but that did not materialize during the 12-month period.

"E-tailing still doesn't represent a lot of retail business in absolute dollar terms," Alexander says, "and pure e-tailers experienced numerous distribution problems during the holidays. More people seem to be of the opinion that the best strategy for retailers today is the 'bricks-and-clicks' combination - leveraging good retail brands with an Internet presence."

But for retail REITs, 1999 was not a good year, Alexander adds, primarily because technology and Internet companies have captured the fancy - and dollars - of Wall Street analysts and investors.

"There are still tremendous outflows from the REIT sector," he says. "Typically, REITs will offer a dividend in the 6% to 10% range, with potential for growth in the 8% to 10% range, for a total return of about 15% per year," says Alexander. "Historically that was a good return. But with the high value of technology stocks, investors today think a 15% return is what you're supposed to receive in a day."

Steve Sterett, senior vice president and treasurer of Indianapolis-based Simon Property Group, agrees. "In the REIT market, return expectations have increased because of the tech boom," he explains. "I would argue retail REITs can consistently produce returns of 13% to 17%. If you look at the historical performance of the stock market, that is a very attractive return given the risk profile of REITs. But it's tough attracting capital to REITs today because people want a homerun, not a single or double, without the risk of striking out."

Industry-wide, Sterett says, 1999 was solid, with a positive overall economic picture and higher consumer confidence. "And while companies like the Gap and Nordstroms are becoming preeminent online retailers, they still need space in malls," explains Sterett. "They are merging place-based and space-based operations."

He adds that shopping malls will not become obsolete because of what they offer in addition to goods. "The social aspects make a mall great. It is a place to see, be seen and is the center of many of our communities," he says. "Today we're also seeing the mall industry begin to take advantage of not only physical retail space - making money from tenants - but also looking at how to connect with shoppers and develop profitable strategic businesses."

Richard Kuhle, senior vice president of development at Phoenix-based Vestar Development Co., says 1999 was a strong year because developers focused more on the right product at the right location.

"I think the growth in 1999 was good. It was positive retail growth," says Kuhle. "Most of the centers that were built, especially from our standpoint, were built at good locations. Companies made sure the projects they developed were going to dominate the trade areas instead of thinking, 'We'll be the second or third guy in and hope it works.' People were looking to get into areas where they could dominate a niche."

In the past, he notes, developers would never turn down a project. That was not the case in 1999. "If it wasn't located in the proper area, even with an anchor tenant, some developers turned down projects," says Kuhle. "It goes back to having the right locations."

Even so, Damian Zamias, president and CEO of Johnstown, Pa.-based Zamias Services Inc., notes that 1999 experienced some instability in the retail tenant arena.

"One of the major occurrences of 1999 that will have a profound effect on our industry going forward is the unsteadiness of theater operators and owners as it relates to performance issues and their financial stability," he explains. "The saturation of theaters, coupled with the difficulty in financing new projects, has caused both the shopping center industry as well as theater operators to consider alternative plans relative to size and real estate strategy. What fundamentally should have become a cornerstone of our growth, and an important component of entertainment retail, is now in question."

Still, retail construction and sales continued in 1999. General Growth Properties made the largest investment in retail property, brokers said, paying some $810 million for Ala Moana Center in Honolulu. Urban Shopping Centers Inc., in a partnership with Chicago-based Walton Street Capital, purchased the 1.6 million sq. ft. retail component of the Houston Galleria. Walton Street Capital reportedly paid $550 million for the entire mixed-use development.

Retail construction continued during 1999, including projects such as The Mall of Georgia at Mill Creek in suburban Atlanta, a 1.7 million sq. ft. Simon Property Group project that not only combines the regional mall and Main Street concepts but is designed to capture the history and geography of the state as well.

Industrial: A fulfilling year For industrial developers and owners, 1999 was a year of fulfillment - literally. "Fulfillment wasthe buzzword for e-commerce companies," notes Gerald O. Yahr, president of Newport Beach, Calif.-based Koll Development Co. "To be successful, many e-commerce companies have to be successful at the fulfillment end, and many companies focus on trying to locate facilities that best service their customer base. In the markets we are active in, we saw a lot of the activity from those types of tenants."

Industrial hot spots in 1999 included South Florida, Chicago and Southern California. "We expect demand to remain good, if not a little stronger, in those markets, but supply in some areas is catching up with demand," adds Yahr.

Location continued to play a major role in industrial development last year. Larry J. Smith, senior vice president of development at Chicago-based Transwestern Commercial Services, points out that the combined efficiencies of the railroad and trucking industries played an increasingly dominant role in the long-term success of manufacturing and distribution operations.

"The demand for intermodal adjacencies to industrial and distribution areas is unprecedented," says Smith. "We're seeing industrial development searching for 'homes' that are rail-served and have close access to a variety of intermodal facilities. The classic example is Ross Perot Jr.'s ultra-sophisticated Alliance facility in the Dallas-Fort Worth area. Hub cities like Chicago, through which 40% of the global intermodal container market passes, are prime contenders for distribution development," adds Smith.

Efficiency was the key word in industrial construction last year as well. "Taller clear heights for both distribution and manufacturing facilities are the norm as dollars per cubic feet replace dollars per square foot to maximize efficiencies," says Smith. "Precast wall panels have replaced block and brick, allowing buildings to be erected and enclosed from the elements quicker."

Most industrial markets were excellent, adds Greg Gregory, president and CEO of Atlanta-based Industrial Developments International (IDI). "The key to success in 1999 sounds too simple: Deliver the right product at the right location at the right price," he says. "We had a fabulous year, a record year, because we followed that philosophy."

Gregory notes that as logistics change, the industry continues to evolve. "For the first time, we saw e-commerce as a real force," he says. "I liken it to seeing a gorilla at some distance coming toward you. You know it's going to get here, but it is a question of when. We saw it face-to-face in 1999."

Hospitality: prosperous plateau The hospitality industry benefited from the strong economy in 1999, says Marc Louargand, managing director at New York-based Cornerstone Real Estate. "Demand for business travel, leisure activities and increased spending on social functions all contributed to a continuation of the recovery in hotels," he says. "Average daily rates (ADR) continued to climb, while operating costs reflected the low inflation rates in the economy at large, resulting in increased operating leverage and profitability.

"We think that profitability will continue to rise in the next few years in the full-service sector, even as occupancies reach a plateau or fall back slightly," he continues.

Robert Mandelbaum, director of research information services at the Hospitality Research Group (HRG), the research affiliate of San Francisco-based PKF Consulting, says there are three words that can said about the hotel industry in 1999: flat, flat, flat. "It was a pretty boring time," says Mandelbaum. "We went through a period of supply growth that was extraordinary, but it has tapered off and the market is in the process of absorbing it. We're not seeing growth in the ADR that we saw in the middle part of 1990s."

Profit margins remained high, he continues, and sellers sought extraordinarily high prices for hotels during the year. "They'd put hotels with these high prices on the market, and if someone paid that price, that was fine," says Mandelbaum. "If not, the owners sat back and still collected their profits."

John B. Corgel, managing director of applied research at HRG, adds that the year started out slowly but did improve during the second half. There were also the sluggish stock prices of hotel companies. "It was pretty flat, particularly with the absence of growth in room revenues," says Corgel. "Wall Street is in love with a growth story; that's what is moving Internet and tech stocks. Hotel companies didn't have a growth story."

J. Spencer Ferebee, senior vice president and CFO of the Ritz Carlton Co., a subsidiary of Bethesda, Md.-based Marriott, says the industry saw some moderation in demand, with supply catching up.

"The luxury tier was probably the strongest," he explains. "Throughout the industry, occupancy was leveling off, with most of the growth coming in the rate. We were a clear exception to that. From the go-go growth of the stock market, lodging was a trailing industry."

Ferebee notes that at Ritz Carlton, occupancy was up 3.9% at hotels that have been open for one full year, and revenue per available room (RevPAR), a key measure in the hotel industry, was up 10.4%. "If not the strongest, ours was certainly right up there," says Ferebee.

Pete Kline, chairman and CEO of Dallas-based Bristol Hotels and Resorts, adds that 1999 was still a good year for the hospitality industry. "I think everybody had a pretty profitable year, and from a public company perspective, it will be remembered as a profitable year - but not as profitable as everyone hoped it would be," says Kline.

Supply that came on-line during 1999 stifled hoteliers' ability to boost revenues as much as they had hoped. "It was a strong year, and I think 2000 has prospects of being better than 1999," Kline adds."The industry is just not growing as fast as everyone would like it to. There has not been an enormous increase in hotel demand. The issue in individual hotel performance now is whether supply is growing faster than demand."

Kline adds that the hotel industry was concerned about potential Y2K problems and, therefore, spent heavily. "We [Bristol] spent close to $15 million, which is a fair amount of money for a company our size," he says."But based on January 2000 results, we successfully avoided any problems."

Multifamily remains strong On the multifamily side, 1999 was a year of expansion. "Industry-wide, we had a good year," says Bobby Page, president of Dallas-based JPI. "We saw capital returning to the market, but capital continues to restrain the markets."

Robust multifamily markets were evident in New England and on the West Coast, with a yellow caution light for areas such as Dallas, Houston and Phoenix.

"Demand continues to be strong in those cities, but the supply is starting to outpace demand," Page explains. "The hot markets include San Diego, Los Angeles, San Francisco, Boston and Virginia. Generally, we saw more infill product being developed during the year."

Last year, JPI reported some $1.4 billion in total capital transactions, he adds. "That was a record year for our company, and we are very bullish about the overall markets, particularly in the Northeast and the West," says Page.

In California, for instance, the multifamily residential housing market continued to show great depth and elasticity, says Alan Casden, chairman and CEO of Los Angeles-based Casden Properties, which is developing 1,600 luxury and ultra-luxury apartment units at Park La Brea in Los Angeles.

"In our development plans, we have identified a strong demand in urban markets for luxury housing that is geographically desirable and amenity-rich as an alternative to home ownership," says Casden. "The expanding Southern California market for luxury rental housing provides significant opportunities to create new housing stock with amenities and features that are otherwise not available in rental housing and are otherwise comparable with for-sale housing."

Joel M. Carlins, president of Chicago-based Magellan Development Group Ltd., notes that multifamily construction, primarily condominiums, was doing well in areas such as the Windy City.

"Chicago attracts a lot of people from all over the country who establish businesses and need a place to live," says Carlins. "Chicago's been an under-built and under-served market for several years. People are doing well and have more spendable dollars. They want to live nicer, and are moving back into the city from the suburbs. As rents go up, people desire ownership."

Year of reckoning For the seniors housing industry, 1999 was a year of change, points out William B. Kaplan, chairman and CEO of Chicago-based Senior Lifestyle Corp.

"The year saw an awful lot of changes, particularly with the public companies," says Kaplan. "We saw one announcement after another from companies indicating a slowdown in their growth and development because they determined it was time that they focused on existing operations. The developments that did go forward needed more attention because the markets were slower than anticipated."

The industry also faced a problem that was pervasive throughout the real estate industry: decreasing investor interest. "Investors determined there were opportunities other than senior housing," says Kaplan. "One of the reasons was that senior housing was sold as a growth industry - growth through development, not through revenue growth. Analysts determined that was not going to happen.

"Companies couldn't maintain that level of growth, and 1999 was a year of reckoning," adds Kaplan. "Companies had pro forma'd that they would have tremendous growth, and increases in 1999 never achieved those goals."

Michael S. Grust, president of San Diego-based Senior Resource Group LLC, agrees.

"I think 1999 was clearly a year where we came to realize that the basic fundamentals of real estate were key, even with retirement housing business," says Grust. "It's a local business. It's not nearly as scalable a product type as people think.

"Wall Street had a love fest with our business," Grust continues. "It flooded money into companies that just went public, and the reality was that some of the fundamental essentials were neglected, such as the need for a market for senior housing. In 1999, the industry saw a lot of development not because it was necessary, but because companies had to generate growth."

The new year will bring consolidation, he predicts, with some public companies trying to decide how to go private again. "It's the unpredictable nature of the business, of entitlements, of having consistent and predictable reporting streams. As a public company, it becomes quarterly-driven," says Grust. "Our philosophy is that this is a business that does have its place. There are markets that are under-served, and there is a need for this product type."

Despite a few bumps in the road, 1999 was a winning year for the real estate industry. While no one expects the boom that has engulfed the industry for the past eight years to continue indefinitely, most experts say 2000 will be a good year for the real estate sector. Time will tell.

Although 1999 might best be remembered as the year for emerging dot.com companies, the commercial real estate marketplace experienced other milestones and transformations. To help NREI put 1999 into perspective, we asked several industry experts from a cross-section of disciplines the following question: "What do you think was the single most significant event and/or transaction in 1999 in your niche of commercial real estate?" Their answers begin here and continue on Pages 54 and 56.

Bjorn Hanson Global Leader, Hospitality & Leisure PricewaterhouseCoopers New York "The Starwood/ITT Corp. merger as well as the Hilton/Promus merger. It's hard to pick one over the other because what happened was Marriott was such the big, dominant, stable player that had the resources, the math and the distribution. Now we have three companies that are just enormous and powerful."

Philip Hawkins COO CarrAmerica Realty Corp. Washington, D.C. "The formation of BroadBand Office Inc. creates an exciting opportunity for real estate companies to profit from telecommunications access to buildings as well as to improve services to our customers. It also results in profit, not just in terms of percentage of revenues, but a percentage of the value created in the equity."

John Bucksbaum CEO General Growth Properties Chicago "My simple answer is the Internet. Every person and every company should be reevaluating how they conduct business, especially in retailing - internal operations, buying product for the malls, negotiating leases and working with e-tailers to bring them into the malls."

John S. Gates Jr. President and CEO CenterPoint Properties Chicago "The bottoming out of REIT share prices. The reason I think that they bottomed out is the recognition that REIT earnings/share price multiples are highly correlated to REITs' forward, 12-month growth rates. REITs have now declined to per share growth rates that are sustainable in the absence of massive common stock issuance."

Adrian Corbiere Senior VP of Multifamily Freddie Mac McLean, Va. "The most important event in real estate in 1999 was the "downsizing" of the conduit originators and the eventual elimination of many firms from the conduit business. Although capital markets have certainly provided (and will continue to provide) some constraints to the financing of commercial real estate, the overriding desire for high volume, coupled with a lack of disciplined and experienced underwriting at many conduit originators, was a recipe for disaster. There may be more fallout in the industry as margins get squeezed, but prudent underwriting seems to have been restored."

C. Cammack Morton President and CEO Konover Realty Trust Cary, N.C. "The results of the 1998 Internet holiday season were significant. The Internet changed the balance of power from the developer and retailer to the consumer. I think the strip shopping center business, due to its large number of service and convenience users as well as grocery stores, is pretty far down the list of endangered retail."

Shekar Narasimhan Chairman & CEO The WMF Group, Ltd. Vienna, Va. "The privatization of public REITs. We have now seen the privatization of Irvine Apartment Communities, Berkshire Realty and Walden Residential. This was reflective of the lack of support for REIT stock values in the public markets and the consequent reemergence of private equity as the dominant driver in multifamily real estate."

Morris Lasky CEO Lodging Unlimited Chicago "Without a doubt, the Hilton/Promus merger. I don't think there was a bigger [deal]. It almost had to happen. Certainly the right people to acquire Promus was Hilton. They're set up for it. They have direction and they have the leadership."

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