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'95 in review: back to the future

Hot town, summer in the city.

A gritty, sweaty tussle for 14 million sq. ft. of prime Manhattan office space, including the World Financial Center - all the property once part of the Olympia & York real estate empire, but now in the hands of banks.

Toronto's Bronfman family looked certain to take control of O&Y (USA) under the company's restructuring plan, but developer Jerry Speyer, president of Tishman, Speyer Properties Inc., tossed a monkey wrench into those plans. He covets the real estate and joined forces with financier Leon Black, whose Apollo Real Estate Investments has been an active buyer of large real estate portfolios. Speyer and Black want to inject $100 million of fresh capital into Olympia & York in exchange for majority ownership.

Olympia & York, which is based in Toronto, saw its international real estate empire collapse two years ago under a mountain of debt. In New York, however, O&Y (USA) has been negotiating a restructuring of $5 billion in debt. Apollo supposedly acquired millions of dollars of the debt, and Speyer in turn bought $10 million of that debt from Apollo.

The squabble, which has yet to run its course, has meaning beyond that congested little island between the East and Hudson rivers. In fact, it sums up a number of trends that have been unwinding over the fast few ears:

* a continued redeployment of ownership for the massive amounts of real estate built or acquired during the boom years of the 1980s; * a return of large, institutional investors to the marketplace, either in the form of wealthy individuals, oportunity funds (like Apollo Real Estate Investments) or pension plans; * the accumulation of property into larger and lrger portfolios run by a smaller and smaller number of owners; and the renewed attraction to what once were undesirable and verbuilt asset classes such as office building and hotels.

About the only thing the O&Y drama didn't have was the presence of a big media company. Well, maybe it had that too. Didn't the Bronfmans take over MCA? And, just across town, isn't Disney Co. trying to buy into Rockefeller Center with its art deco-adomed office buildings?

If you thought the entertainment value of real estate was a thing of the past, look again. The marquee on almost every city across the country reads "Real Estate - Back to the Future."

"What has happened in the last year had been a spreading of the national recovery," opines Hugh Kelly, director oeconomic research at Landauer Real Estate Counselors in New York. "Offices have started to come up the curve. There is stability in occupancy rates and a noticeable trend upward in market rents."

There's a lot of investment interest in real estate, adds Gary Lanz, worldwide director of real estate at Arthur Andersen, Los Angeles. "There's quite a bit of interest out there in the marketplace today for existing structures, not new construction." He cites Tishman Speyer, Disney and Zell as being active buyers. (At our deadline, a partnership of Disney, Zell and General Electric had just made a second bid to take over the Rockefeller Center property. This most recent bid came after offers by Gotham Partners and a partnership of Goldman, Sachs & Co., David Rockefeller and jerry Speyer.)

Office and industrial market

The office market continues its strong rebound through the first half of 1995 with the national metropolitan vacancy rate declining to 14.7%, reports CB Commercial. This rate represents a 0.4 percentage point decline between the first and second quarters.

The downtown vacancy rate is 15.3%, a decline of 1.3 points from the vacancy rate of 16.6% one year ago. Meanwhile, the suburban vacancy rate is currently at 14.3%, a decline of 1.8 points from the 16. 1 % at the end of second quarter 1994.

Some observers think the improving trend line will favor suburban space at the expense of downtowns.

"Downsized corporations still located in the central business district may be considering a move out of town," says Michael Evans, national director of E&Y Kenneth Leventhal Real Estate Group. "The return of suburban offices nationally could be a tough blow for central business districts that have been encouraged in recent months by improved economic conditions."

There has been a return to single-digit vacancy rates, particularly in the suburban class of properties, adds Landauer's Kelly. "This is a story that is going to continue."

What also might continue as a positive on-going story is industrial properties. According to Grubb & Ellis, the national vacancy rate for industrial properties decreased by 0.4% to 10% in the second quarter. Big declines were chalked up by warehouse and manufacturing which fell 4% in the second quarter, while average lease rates for R&D dropped 8.3%.

In addition, Grubb & Ellis reports the industrial vacancy rate has declined 0.6% over the last year with 11 of the top 20 major markets recording vacancy rate declines compared to only five markets that recorded vacancy rate increases.

While there have been few sightings of office construction activity, industrial building construction has become commonplace, including both build-to-suit and speculative space. Indeed, the percentage of speculative space construction has risen 15.8%, up nicely from 5.7% in the fourth quarter of 1993.

Demand is up for industrial space and to some extent suburban office space.

A phenomenon this year has been development of entertainment venues, with the Rock'n Roll Hall of Fame opening in Cleveland, as well as a slew of new sports stadiums and arenas, including Denver's Coors Field, Cleveland's Jacobs Field and Boston's Fleetcenter.

Fleetcenter is doubly significant because it reflects the return of insurance companies to the real estate investment realm. The $130 million of permanent debt, which was arranged by Boston-based Fowler, Goedecke, Ellis & O'Connor Inc., was provided by five life insurance companies led by New York Life Insurance Co.

Financial institutions have recognize there is need and are making capital available for developers once again. "If you meet the right loan-to-value, if you have the right debt-service coverage, institutions will lend," says Lanz. "It is not like a couple of years ago when there was no money available for new development."

There is a lot more liquidity in the bank markets, observes Robert Blumenthal, managing director in Real Estate Investment Banking Group of Bankers Trust, New York. "Banks are back with a vengeance."

For quality developers who are building well-anchored retail product, or a substantially leased office or industrial product, there isn't a lack of money available or development finance. A year ago, the bank finance market was spotty, but "this year it is a flood, says Blumenthal.

Capital markets

When real estate prices collapsed in the late-1980s, traditional lenders such as banks, savings and loans and insurance companies retreated from the market rather quickly. But into the void stepped Wall Street. Through securitization of debt, and equity in the form of real estate investment trusts, Wall Street quickly became a major player in the real estate industry. However, as Roger johnson, national industry director for KPMG, Chicago, notes, after numerous interest rate increases and the return last year of traditional lenders, "The flow of real estate accessing the Wall Street capital markets has eased up."

When the United States began to crawl out of the global real estate recession of the early-1990s, the focus of property markets shifted from the traditional inter-relationships of private companies and small investors to Wall Street and institutional investors. Concomitantly, the vehicles for raising capital to either refinance existing developments or construct new buildings increasingly shifted from the private to public markets.

The favored Wall Street method of raising capital for real estate has been securitization, either with debt in the shape of commercial mortgage-backed securities, or equity in the form of the real estate investment trusts (REITs). By 1993, commercial mortgage-backed securities grew into an $18 billion business and REITs raised a record $16 billion. Since then securitization has slowed.

Last year, debt securitization reached $20 billion, while new REIT capitalization actually retracted to $14.7 billion. Both debt and equity securitization will probably be down this year.

While it is doubtful that Wall Street will ever be a primary lender to developers, it has become an important player through the mortgage conduit process - where Wall Street sets up a relationship with mortgage originators to accumulate commercial loans, and when the loans total $50 million to $100 million, they are rated and sold as securities. Last year, it was a $2.7 billion business and this year business could easily exceed $3 billion.

Part of the problem for conduits is that when the cost of securitization is added to the trading levels of commercial mortgage backed securities, the capital markets may be more expensive than the cost from traditional lenders that returned to the market.


Wall Street's equity securitizations are commonly in the form of REITs. After two spectacular years of capitalization, this market fell apart in 1994 and is still struggling in 1995. Through the first seven months of this year, REIT stocks rose 9.46%, which wasn't bad, but looked weak compared to the S&P 500, which jumped 24.19%. From July 1994 to July 1995, REIT prices rose 6.66%, as compared to the S&P 500, which ballooned 26.10%.

"What gets lost in the analysis for REITs," says Jon Litt, a real estate analyst for Salomon Brothers in New York, "is that we expect REITs to return 12% to 15% and this year we are sort of on track to hit 12%. That pales in comparison to the S&P."

In 1994, Prudential Securities raised over $4 billion in public equity. This year it won't raise as much money for the REIT industry, but broadly speaking it will do more business for it in 1995 than the previous year. "As this market developed and matured, the companies found they needed many different types of capital," says Richard Schoninger, managing director and head of the Reat Estate Investment Banking Group at Prudential Securities in New York. "The REITs are using more sophisticated forms of debt to better manage their companies. What started off as just raising equity has turned into underwriting debt and issuing perpetual preferred stock to help these companies grow."

New public offerings for REITs are way down this year, mostly due to lower stock prices and higher interest rates, but to some extent this is also because so many real estate companies went public in the prior years. REITs, however, "are still raising a ton of money," Litt asserts. By the beginning of last year's third quarter, REITS raised over $5 billion. This year, REITS have quietty raised over $4 billion in equity issues. "I don't see why REITs should not be able to sell $4 billion to $6 billion worth of equity year in and year out," Litt says.

Ned Davis, an analyst at C)ppenheimer & Co., New York, is not so sanguine about the REITs' ability to raise money. While recognizing "a fair amount of equity was raised this year," he says it tended to be concentrated amon a small handfiil of the larger, more highly regarded REITs. Nevertheless, he feels the industry has made some great strides at improving its balance sheet, reducing floating rate debt exposure and increasing equity capitalization as a percentage of total assets.

Over the past two years, REITSeflushed with cash, ventured dee into ac ulsitions, especially with regard to such asset classes as multifamily. This activity has leveled off as the tremendous amount of distressed real estate that was available for REITS has finally diminished, and what is out there is more competitively priced. Still there were some main or plays last year, such as General Growth Properties acquiring, along with some institutional investors, the Homart portfolio of 26 regional shopping malls for $1.5 billion, and Prudential Insurance's Centermark portfolio of 19 shopping centers for $1 billion.

Davis expects REITs to push into the development market, parecularly in the multifamily sector. "REITs are finding they can get better rates of return on development than they can on acquisitions. And REIT to some extent can absorb the risk and uncertainty of development."

In regards to investment appreciation, the sector of the REIT market that has performed best this year has been self-storage, which has been up 19%, and hotels, 7%. "The storage sector reflects as great business benefiting from consolidation," Prudential's Schoninger, "while the hotel sector is continuing to benefit from a recovery in tourism and business travel."

The lodging industry

Hotel REITs are still a small part of the REIT market, but their improvement is noteworthy because hotel REIT share prices can be seen as a reflection in the sudden buoyancy of the hotel industry.

The action in the lodging industry is still with existing hotels as investors, including REITs, attempt to build larger and larger portfolios. There is some new construction, but it is still at a very moderate pace. Taking into account projections for 1996, it's estimated the annual supply of new hotel rooms in the five year period 1992-1996 will increase an average of less than I % per year. During that same period of time, the demand for hotel rooms will have increased 3.2%.

Except for just one year in the nine-year period from 1987 to 1995, demand for hotel space has outstripped new supply. The effect of this market imbalance has been improving occupancy rates. In 1994, occupancy rates for the U.S. lodging industry notched 68.9%, will average about 70.2% this year and should reach 71.2% in 1996.

"The industry is in its third year of full recovery," says Robert Mandelbaum, director of research for PKF Consulting, San Francisco. "Occupancy was the first thing to grow since the supply side was kept in check. The economy is doing better, while the volume of business and leisure travel improved annually."

Better occupancies have allowed hotel companies to boost rates. The average rate in 1994 was $81.68, and should hit $85.24 this year with projections for $88.10 in 1996.

In addition to those basic numbers, hotels are operating with more efficiency.

The U.S. lodging industry restructured over $2 billion of annual interest payments, which has had a net effect of lowering the cost of borrowing, reports Bjorn Hanson, hospitality industry chairman at Coopers & Lybrand, New York. More importantly, the industry has reduced the number of employees from 87 per every 100 rooms in 1987 to 81 employees per every 100 rooms. These changes have led to a dramatic improvement in profit margins. Operational profits have been getting better every year since 1992, says Mandelbaum. This year, operational profit margins as a percent of total revenue should reach 25%, which would make it the best average since 1980 and the second best average since 1960.

"Basically, hotel operators have improved efficiencies and are bringing more dollars to the bottom line than ever before", Mandelbaum says.

More dollars are also being pumped into the industry in general.

Although REITs still represent a small percentage of hotel ownership, they have been very aggressive in raising capital. Last year the lodging industry's debt and equity offerings totaled $1.5 billion, and through july of this year it had already reached $1.3 million. Much of the capital raised will be used to acquire new properties. "We are seeing a very collective industry as far as ownership changes," observes Hanson. "Wall Street's impact on the lodging industry is not necessarily capital formation in support of new construction, but refinancing of existing properties in order to change ownership."

There have been 10 major lodging industry consolidations over the past two years, including Forte buying Meridien hotels, Radisson merging with SAS International Hotels, ITT Sheraton taking on Ciga and Caesers World, Marriott buying Ritz-Carlton, and Interstate Hotels Corp. locking up Colony Hotels.

In fact, the lodging industry is reflective of the whole real estate market, where restructuring and infusions of capital are putting large portfolios of property into the hands of new owners.

Institutional investors

Paul Garity, a partner in KPMG's Los Angeles office and head of its Real Estate Consulting group, was surprised to find his company continues to be involved in bulk sales of real estate. "We just thought that market was going to dry up," he says. But it hasn't. KPMG recently consulted in the bulk sale of distressed properties for Glendale Federal, a California savings & loan, and signed on to help unload property for a Japanese bank - its third arrangement with Japanese financial institutions to divest U.S. real estate.

What isn't surprising is that traditional institutional investors have been in the bidding for bulk divestitures. Goldman Sachs' Whitehall Fund was the winning bidder for the package of Glendale Federal's distressed loans. If anything the field has gotten even more crowded as 1995 was a comeback year for opportunity funds. When the first wave of distressed property sales waned around 1992 and early 1993, opportunity funds retracted from the market, but beginning last year a whole wave of newcomers entered the game including funds from Blackrock Financial Management, Koll Co. and Lincoln Properties.

"There is still some pretty heavy competition for bulk sales," says Garity.

Values are going up and cap rates are going down, adds Blumenthal. But investors are still buying buildings at what they perceive to be at or below replacement costs. "If you have a quality portfolio, it is a seller's market," he says.

Buyers often are partnerships between operating companies and pension plans. For example, General Growth's acquisition of Centermark and Homart was basically financed by pension fund money. Houston-based Hines Interests' purchase of 18 office buildings, also from Homart, was a joint venture with Morgan Stanley Real Estate Fund II.

John Kozar, director of real estate consulting at Tacoma, Wash.-based Frank Russell Co., suggests a number of important changes in investors or investment strategy by institutional players:

* Today's investor is more flexible as far as what type of investment vehicle will+ be looked at, including taking shares in a public real estate operating company or doing private placement in public REITs

* Pension plans will remain active buyers, because in the past few years, many allowed real estate allocations to dwindl and now they are trying to get back to target levels.

Some pension plans which had a 10% allocation to real estate, or, for example, a $100 million target, fell to 5% allocation and will need to add another $50 million in investment to get back to the 10% allocation.

* Unlike the 1980s, when investors were passive and invested in vehicles where they essentially gave up direct control, today's investors tend to be activists, perhaps taking seats on boards of companies in which they have invested.

Despite these salubrious changes in the investment world, Kozar cautions, "It is important investors keep focused on fundamentals and not succumb to the notion that they should be fully invested as rapidly as possible.

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