Good times: capital markets hit equilibrium

Compared with the wild fluctuations of the stock market and the plummeting values of e-stock, the capital market is an oasis of calm. "Stable," "steady" and "predictable" are some of the words experts used to describe today's capitalmarket climate at a roundtable sponsored recently by Columbia University and National Real Estate Investor.

Panelists representing financial intermediaries, debt issuers, pension funds and other interests discussed trends and issues in capital markets. The consensus: Real estate markets are in equilibrium, with stable investment returns and a good balance between supply and demand.

Even though the panel predicted interest rates will rise - a correct prediction borne out by the Federal Reserve's half percentage point interest hike in mid-May - the panel agreed most investors will stay in the market, thus preventing a collapse. However, some panelists pointed out some weak spots in the market such as retail and hotels.

Good fundamentals Gerald Cohen, director of New York-based Ernst & Young's Kenneth Leventhal Real Estate Group's Capital Markets Practice, was optimistic on the state of the industry. "Fundamentals are good, and the real estate market has exercised greater discipline, which has resulted in little overbuilding, strong occupancy and solid rental rates," said Cohen. "Since the capital crisis of the summer of 1998, real estate capital has gone for quality, and the capital markets industry as a whole is more mature, exhibiting uniform thinking due to pressures from, and oversight by, Wall Street."

He was joined in that assessment by Meg Blakey, vice president of New York-based Goldman Sachs & Co. "Equilibrium has been reached, and CMBS issuances have begun to level off," said Blakey. "However, demand for quality paper means that real estate will be able to compete with corporate bonds. We are now entering a period of stability."

The volatility of other investment options is benefiting capital markets, noted Jeffrey Barclay, managing director of New York-based Clarion. "When other investment returns in the cycle vanish, then property proves to be good diversification," he said.

He went on to predict: "Steady, predictable returns on cost, with steady production." Barclay also noted that pension funds have big appetites for core investments, which in real estate represent holdings with steady 10% to 11% unleveraged returns.

Weak markets While the panel was generally bullish on the state of the industry, some panelists noted weak areas. Paul Fried, director of New York-based Deutsche Banc Mortgage Capital Group, noted that life insurance companies and E-banks are adopting new, more transparent pricing policies - including marking to market on a daily basis - which isn't suitable to the longer value appreciation cycles of real estate.

Fried also pointed out another problem area. "Fundamentals are not necessarily good from the owner/operator perspective, as Wall Street pricing has driven down values, particularly for REITs, and as the CMBS markets seek to refine the product-matching for investors seeking nice, clean fixed-income paper secured by real estate," he said.

Dan McNulty, managing director of New York-based Redwood Realty Advisors, said pension fund buyers are likely to face uncertainty about where to reinvest capital. "Most pension fund buyers are spoiled by the tremendous returns of the past three years, and with more money than ever in their tills, they're struggling with where to place it," he said.

He also noted two areas of concern: Big-box retail, which is faced with E-commerce competition, and hotels, which have seen a flattening of revenues and occupancy rates.

Some confusion Steve Kohn, managing director for New York-based Sonnenblick Goldman, agreed that market fundamentals are strong, especially now that investors don't have to compete with REITs for quality properties. However, he expressed concern over the possible credit risk of meeting the fast-growing space demands of companies.

He also said there is some confusion among buyers about what type of investments to make. "Buyers this year don't know whether to go long or short, demonstrated by the run-up in interest rates and coverage requirements," he said. But this isn't necessarily a bad thing. "We prefer inefficient markets, with mass confusion," he joked.

The latest trends Panelists weighed in on trends affecting capital markets, from the proliferation of E-banks to the conversion of older buildings in many cities due to low vacancy rates in Class-A buildings. According to the panelists, trends include:

* Investors returning to the fundamentals of real estate and looking for quality assets. Having received high returns from investments in the stock market, pension funds are looking to real estate for stability and diversification rather than high yield.

* Pension funds investing more heavily in real estate to diversify their core holdings.

* Property markets becoming more institutionalized as larger players increase their holdings and gain prominence. The consolidation of companies, capital and expertise are pro- moting a standardized real estate product and stifling creativity.

* As technology stocks become overvalued, investors are starting to look away from appreciation-based returns and again toward income-based returns.

* Class-B and Class-C buildings are becoming marketable in some cities due to low vacancy rates and the need for high-tech space.

* The proliferation of E-banks is putting pressure on traditional lenders and commercial banks, forcing them to become more efficient and cut margins. This heightened competition is creating a favorable environment for customers shopping for capital.

* REITs disposing of assets to pay debt or to fund growth since their ability to reinvest is marginal.

* Investors shying away from investments in retail because of the potential impact of E-retail. The stability of traditional forms such as regional power centers and malls is no longer secure now that customers can purchase more goods on-line.

The Columbia Roundtable panelists predict:

* real estate is close to the end of a historic cycle - but there is no collapse in sight;

* more quiet industry consolidation;

* more collaboration between CMBS issuers;

* REITs will concentrate on selling property;

* higher interest rates over the short term;

* pension funds will be the "power hitters" in the industry; and

* new E-commerce capital markets will evolve.

Paul Fried Director Deutsche Banc Mortgage Capital Group

Meg Blakey Vice President Goldman Sachs & Co.

Steve Kohn Managing Director Sonnenblick Goldman

Dan McNulty Managing Director Redwood Realty Advisors

Kevin Fitzpatrick Managing Director AIG Real Estate Group

Gerald Cohen Director Ernst & Young Kenneth Leventhal Real Estate Group

Carol Nichols Managing Director ESG Capital

Jeffrey Barclay Managing Director Clarion

Michael P. Buckley Director Columbia University Real Estate Development Program

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