A `chilling' interest in suburban office product

Institutional advisors warm to idea of greater balance in portfolios.

What do you get when you mix asset managers with institutional advisors and a REIT executive thrown in for good measure? A recipe for an engaging, thought-provoking conversation about the big-picture trends in commercial real estate. NREI teamed up with New York-based Insignia/ESG to host a roundtable panel discussion earlier this fall at the Phoenician Hotel outside Phoenix. Executives from 10 leading companies discussed their acquisition and disposition targets for this year, market trends, and concerns looming on the horizon for 2001. A question-and-answer period followed the event. NREI would like to give special thanks to Kevin Haggarty, executive managing director of Insignia/ESG for moderating the panel discussion. An edited transcript follows:

Kevin Haggarty: We'd like to know what your expectations are for the acquisition and disposition programs you had in place for this year. We'd also like to know how you found the investment climate this year. Were there any changes in the investment climate in tertiary and secondary markets or in suburban vs. CBD that caught you by surprise, or that concerned you? Additionally, we'd like to know your thoughts on the availability of debt with rising interest rates.

Thomas Klugherz: For the year, we generally found the climate fairly consistent with the end of last year. There was a little bit of activity built up at the end of last year, but going into this year we have maintained our pace of investments.

We expect to do between $300 and $400 million this year, which is what we'd set at the beginning of the year to accomplish. Pricing in the markets and market segments we're in have remained competitive. The pension funds, it's been no secret, have continued to be very active in the market. The REIT activity has continued to be low, and it's allowed us to execute.

On the disposition side, we are moving approximately $250 million worth of real estate. We did more harvesting I think in the late '98, early '99 time period, when pricing was a little bit higher. And right now we just continue to cull in a fairly disciplined approach to it.

In each one of the major metro areas, we look at four major product types, as each one being a market segment. Primarily we are in multifamily, industrial, retail and selectively we're looking at office across the markets, mostly in CBD's. We're holding most of our office at this point because of cash returns in those areas where we've had a strong run-up in rents.

Steve Graves: We're looking at doing about $800 million in acquisitions this year and probably about $1 billion in dispositions. The dispositions really are driven by our largest client, Principal Life Insurance Co. We've had a fairly large real estate exposure over the years. The company has just recently announced that it plans to pursue demutualization, and it wants to get the real estate exposure down.

We had been holding onto a considerable amount of foreclosed REO's from the early 1990s, a number of which were held in secondary markets, probably not of A-quality certainly, and that has been difficult to move. That was not a surprise to us, just a continuing theme. We're not having a lot of problem moving good-quality projects in main markets. You get off the beaten path a little bit, and it falls off quite a bit.

Haggarty: Are you still doing debt?

Graves: Yes, we are. We just recently had about a $600 million securitization of our portfolio, which was very well received, and we really outperformed a lot of our expectations. In terms of repositioning, the life company's not terribly active. We're finding on the debt side most of the interest is really coming in "BB" CMBS, lower-grade CMBS, as well as bridge loans and a little bit higher-yielding types of instruments.

James McWalters: At PM Realty Advisors, our targets for this year were to acquire $400 to $500 million and dispose of about $100 million. We probably will hit those targets. We are focused on warehouse/distribution properties and suburban kinds of office, retail and multifamily properties. We've experienced the competition pricing us out of a number of markets. We have gotten to that point where we've said, "We just can't buy at this price in this place right now."

It's the first time I can remember since the REITs were very active where we've had substantial bid-outs in these kinds of markets. And we are seeing some large 1031 (tax-free exchanges under Section 1031 of the Internal Revenue Code) trade buyers enter the fray. We were bidding on a large industrial investment and were in the $44 million range and ready to go to contract. Out of nowhere a trade buyer came in at $48 million and took the deal. So, we're finding it increasingly competitive on the buy side. On the sell side, we have been surprised that some properties that we are selling in our secondary markets have multiple bids at prices that exceeded our expectations.

Marijke Lantz: Are these stabilized assets that you're getting multiple bids on?

McWalters: Yes, as stable as they're going to get. We have an office building in a smaller Midwestern market where the micromarket was so tight that the major tenants in that market have all decided to go build facilities elsewhere. So, there's an expectation of vacancy in the submarket two or three years out when those moves are done, which hasn't hit the market yet. Leases in those buildings will expire in two or three years and are typically three- to five-year terms. Yes, they're stabilized but subject to the usual 20% to 30% annual vacancy lease rollover risk. But again, [these properties] are exceeding expectations on these sales, which is surprising. They're private buyers.

Benjamin Gifford: We had an acquisitions program with a target of around $1.5 billion of new business. On the disposition side, we probably targeted $500 to $600 million of dispositions. Speaking of dispositions, our experience is that in the last month or two we've seen a real chilling in the market, particularly for suburban office or larger suburban office. We've really seen the markets cool down. And for those properties we have had fewer bidders. Maybe the quality or size of the projects is such that they're scaring some people away.

On the acquisition side, I think that basically we believe we see in the market a chilling of interest in office, particularly suburban office. That may present a buying opportunity with portfolios seemingly overweighted in office. We're starting to see a real enthusiasm for industrial and multifamily, so it seems like that those two sectors are getting very expensive right now.

And retail sort of floats on its own. There are very few major malls that aren't in institutional hands, and the small-center business is very spotty. There's not a lot of depth of demand for small centers on a one-off basis among the clients we represent.

Charles Schreiber Jr.: KBS' investment strategy has been pretty similar since 1992, and we're really an opportunity fund. About 70% of what we invest in is office space. This year we'll buy about $600 million to $650 million worth of real estate, and we'll sell about $600 million to $700 million. We also saw slowing in the closings of our dispositions during the second quarter. During the past 45 days though, the momentum has picked up. But we're pretty cautious, and we're seeing the sales in the suburban markets really slow down. In some cases, we've anticipated having a half-dozen qualified buyers on a piece of property, and when you get down to it there's one or two.

With our strategy, which is basically to create a stable investment with an asset over a three- to five-year hold, we're sellers. We're going to sell the asset, whether we can generate our targeted return of a sale price of $10 million, or we sell it for $9 million. We're turning the funds, but it's been pretty slow the second quarter.

One thing that really surprised us the past year is the [1031] exchange buyers. We've probably sold 12 or 13 properties that range in pricing from $6 million to $27 million to exchange buyers. We sold a $23 million shopping center to an exchange buyer, and the buyer had almost $14 million worth of equity that it was exchanging. I thought exchange buyers bought fourplexes and duplexes. It was incredible. And they're great buyers because they've got a time schedule.

We're about on target for our acquisitions. What's changed, though, is we're buying fewer assets and larger assets. And we're finding those assets available in the marketplace in primarily major markets.

Matt Valley: Charles, what do you attribute this exchange buyer phenomenon?

Mr. Schreiber: Well, some of those people actually bought properties in the early 1990s or mid-1990s. They went in and exchanged at that time, or bought properties that, were good $10 to $12 million investments, and they might have been multifamily investments, they might have been other disciplines, but there's good demand for their product. I think the perspective is that they can sell it, they can buy it for $10 million in 1994, and there's a buyer for $22 million today, in their mind they think that the value is somewhere between 10 and 24.

They're pretty happy with that $24 million. It's far beyond what they ever expected if they bought a piece of property four, five or six years ago.

So they're happy to take that profit and go out and buy another piece of property that's going to generate cashflow. So I think that the experience we've found are those buyers are trying to find assets where they can buy an investment with roughly 50% debt, and they can get a good cash yield on the asset, which they weren't getting on their other property.

I think their other properties frankly were multifamily properties, and they were West Coast.

Stephen Latimer: I find it interesting, as I think about this question, that I describe our acquisition process this year as a tough year. I lost track of how many years of expansion the economy has been going through, but we've worked hard on the acquisition side this year to get the assets that make sense for us.

We were targeting to do somewhere between $750 million and $1 billion worth of acquisitions this year and about $200 million worth of dispositions. In the early part of the year, I think we were finding better opportunities. In the second half of the year, we're struggling a little bit more. We still have seen some pretty good office investments, but we are trying to deal with the issue of being overweighted significantly in some portfolios on the office side. We're also trying to find a better balance in industrial, residential and retail.

In some of the markets the operating results have been so good that we as buyers are having a hard time believing it, particularly because they've only been so good for a relatively short period of time. In places like San Francisco and Boston, in particular, and a few of the other major cities, rents have just really gone off the chart. You really struggle with, `OK, how do I really underwrite this thing? What do I really think I'm going to end up getting from a cash-flow return standpoint over the next five years?' It has just been a very hard thing to get your hands around because you really don't have a lot of history to look back on to get yourself some comfort in terms of what lies ahead.

Schreiber: What are you using {to determine} market rent in San Francisco? If you're looking at a building that's across the street from a facility that just leased a full-floor space to somebody for $75 per sq. ft., and you're projecting your market rent three years down the line when your two floors vacate, what's your market rent?

Latimer: Interestingly, that's the big conundrum about buying office. You can buy those kind of buildings in places such as San Francisco and Boston, and make assumptions that the rents are substantially below that $75 number, and still make your numbers work.

Eli Khouri: My comments pertain to office and industrial on the West Coast. We're going to end up selling just under $400 million of product altogether. It's predominantly industrial. The market for that has been very strong and basically institutional. A lot of pension funds have felt under-allocated to industrial and have aggressively pursued the industrial product that we've been selling.

We're going to end up buying about $350 million in office. We're focused on the prime West Coast markets. We're focused on multi-tenant office product. We've done pretty well this year, but I see it getting more and more difficult as time goes on. In my view, things are getting fairly expensive on the West Coast. Land is getting expensive, buildings are getting expensive. And we're finding it tougher and tougher to redeploy those dollars. I think we're still focused on development. Our markets are very tight. I'd say north of Southern California, Northern California, and the Pacific Northwest, vacancy rates are 3% or 1%, or whatever. We have a pipeline of land that would allow us to build another 700 million sq. ft. or so. We'll start that in the right markets to get the very best returns.

There is a gap between the top-tier assets on the West Coast and secondary assets, and there's just a big spread. You see somebody selling something that is what I would call a subprime asset. The bid asked is large and people will put them out there, but they won't get the price that they want and they won't sell them. You may have three or four buyers for the top-quality assets, but you definitely get strong pricing and you can get those deals done without too much trouble.

Lantz: We are selling about $1 billion this year across the country in a lot of the secondary markets. Our sales on the West Coast and the East Coast continue to do very well. There's a lot of activity and demand for the coast cities, and we have a lot of bidders for those. Right now we're on track to hit our goal for selling about $1 billion. We've sold about $760 million so far, but we've got a big fourth quarter coming up.

Our acquisitions for the year are also going to be close to $1 billion. We had a big portfolio earlier in the year, which really helped. Beyond that our single-asset acquisitions have really slowed down. We're doing a lot of the new tech acquisitions, going out and buying some of those buildings where we can restructure them. If they are big, empty buildings and they're on a fiber line, we're going to fill them up with all the tech components.

It's going to be interesting to track some of the sales after going through the whole regeneration of these buildings and filling them up with all the tech spaces. But as far as our disposition and the activity, it's been fairly consistent this year. On our smaller properties, $25 to $30 million, we're getting activity. There are a lot fewer buyers for anything over $50 million.

And with pricing there's also a big disparity between our expectations vs. some of the sellers' expectations on some of those bigger deals. Where we have strong markets and good yields, we're going to hold those assets. We think everybody's over-allocated in suburban office, but when you have a strong asset you want to continue to hold it in those markets.

Kevin Stotts: I think many of you in this room have known us as net sellers of real estate over the last few years. We sold 128 transactions in 1999 totaling about $1.6 billion, and we'll sell about $1.2 billion this year, a lot fewer transactions. But I think this is sort of the turning point for us. We went into 2000 with an acquisitions target of probably around $500 million. And we've already exceeded that goal mid-year and expect to acquire close to $1 billion in real estate this year.

We have several pockets of capital at AEW. We have a $1 billion real estate securities fund that we manage. But then we have two pockets of capital that invest directly in real estate. We have our high-yield private equity fund. It's called our AEW Partners Fund, which has a back-to-basics strategy. To the extent that the economy turns down, it needs to be closer to the primary cities because it's not really getting paid for going out into the niches, so it's back-to-basics major asset classes are San Francisco, New York. And they also are making some small bets in real estate technology companies as well as some other international property markets.

Our core and core-plus separate account money also is focused on San Francisco, New York, Washington, D.C., Boston. They also are investing in urban residential, CBD office, some grocery-anchored retail, and also some assisted living with very proven operators.

To the extent that the economy turns down, the strategy is that we're going to feel better because we're close to the primary cities. To the extent that the economy continues to move along as it has, we're still going to feel better because we think there's a lot of growth left in those primary markets. So the strategy seems to work both up and down.

Lantz: Are you going into secondary markets at all?

Stotts: We are not going to secondary markets, but I am pleased to report that we've had some success in selling one of the few Class-B malls in a secondary market this year. I'm in charge of dispositions, that was a real plus for me. Not many people are selling those this year.

Scott Darling: Our theme is going to be quite similar to some of the other pension fund players in the room. I think we are all facing many of the same issues in terms of our clients' allocations. First of all on the acquisitions side, we tend to be a middle-market buyer. We're buying assets from $5 million to $40 million. We're also one of the smaller groups in the room, so our target was to acquire about $250 million in real estate this year. And I think we're going to be able to hit that. I think we've had to work harder to get there, and I think we've seen some problematic pricing on some of the products in some of the markets.

On the disposition side, we'll sell about $150 million in product. It's included suburban office, it's included industrial properties, and we've seen a very clear distinction in the competitiveness of those offerings.

There have been fewer offers for the suburban office product, less competitive offers. On the other hand, the industrial product has generated lots of offers, very competitive offers. We just did a $25 million transaction where the top seven offers were within 3% of each other. The difference between the initial offers and the best and final offers were significant. So it's a very, very competitive product type. And in addition to the 1031 exchanges, we've also seen interest from the telecommunications hotel, or the server farm buyers.

Haggarty: Looking forward to next year, what are you most concerned about? Is it balance of trade, oil prices?

Darling: Very generally, it's sustained growth in the economy. The fundamentals of real estate have been very solid for the last few years with supply and demand essentially in balance. But our concern is that a lot of that's demand driven. I think markets that we had thought were going to be overbuilt showed a remarkable ability to absorb space.

Lantz: One of the big issues going forward on the investment side is the way people are underwriting these assets because in a majority of the markets we're reaching equilibrium. I think throughout the country, consistently, nobody is underwriting the significant rent growth, even in the markets like Boston or Northern California. You can't continue to underwrite significant rent growth in those markets. And in the central U.S., where you still do have a consistent market performing, I think the way people underwrite those assets is going to be much, much more conservative going forward. They're going to do 3% rent growth, and that's going to impact the values.

Stotts: I think we're going to be watching the dot.coms very carefully. I think the economy has been strong, but if that dot.com bubble bursts, there will potentially be a lot of space coming back on the market. And once those companies have burned through that cash, there's nothing left.

Khouri: There's a lot of venture capital money waiting to fund the next round. There could be a continued churn. I sit in Silicon Valley every day where a lot of this is happening, so maybe my perspective is slanted toward the people there who tell a good story. But if you look at the levels of venture capital investment, and you look at the pipelines of continued venture capital investment, everybody expects continued failures in that arena as well as continued funding for companies. There's going to be something closer to a churn rather than meltdown in that particular sector of the market.

Latimer: We're probably spending a lot of time continuing to focus on the supply side as opposed to the demand side. Most real estate recessions, as opposed to economic recessions, are supply- driven, not demand-driven. And if the economy goes in the tank, the stock market's got issues, the bond market's got issues, the real estate market's got issues, we've all got issues that we're going to have to deal with along the line. We're continuing to focus on what's happening on the development side

McWalters: Our view for a couple of years has been that the real estate markets are somewhere in that high plateau area, and where we historically see some kind of a correction. But having said that, it seems to me that supply and demand, yes, are pretty much in balance around the country.

We've seen a few markets where they have gotten out of whack. I can think of warehouse/ distribution markets in the eastern segment of Chicago where vacancies went to the 12%, 14% or 15% level. Yet six months later, or nine months later, they're back in single digits. And the same holds true with office product in Nashville. If we have an economic downturn, the demand side will suffer. So our response to all that is to try to posture ourselves in such a way that insulates us from that scenario.

Graves: Just a few bullet points. On technology, we're concerned about the amount of venture capital that's flowing into the markets at record levels. If you look at the number of IPOs among the companies that are getting this money and how many of them are actually making money, that percentage has gone down dramatically. We think there are going to be a lot of people very disappointed with those investments, and so we take more of a negative view toward that.

Probably the thing that's not well recognized is the lack of focus on the old-economy companies and their ability to take these new technologies and apply them to lower their cost of business. We look at some of the technology areas and we're probably a little bit on the bearish side. We look at some of the areas that are not getting a lot of attention today; we're probably more optimistic about those in the long run.

Klugherz: We have not been buyers this year on the West Coast in any of the high-tech markets. We are focused very heavily on the supply side. How long the demand side is going to run, what is the length of that market, nobody knows.

Some of the fundamentals give us pause in some of the areas where we do have office, where the technical job growth is dropping and rents are going up at a time when you'd usually see people cutting back. And the number of employees per thousand square feet is rising. So all those things would indicate you'd see some contraction in the market.

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