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More tortoise, less hare

Lend Lease "Emerging Trends" survey forecasts equilibrium for 2001.

Everyone knows the story of the tortoise and the hare. Slow and steady wins the race. According to Lend Lease Real Estate Investments and PricewaterhouseCoopers, that scenario will prevail for commercial real estate in 2001 as never before, with real estate offering perhaps its most stable returns ever, even outperforming the stock market.

"Leasing activity is strong, the economy is strong and, generally, the markets have remained in balance," says Jerry Barag, chief investment officer at Lend Lease. "There's an overall bias toward larger cities, the better opportunities lying in the larger cities with 24-hour components to them. Absorption is very strong, and in a lot of ways that's supported by the Internet and the tech sector," Barag explains.

With "Emerging Trends in Real Estate 2001," Lend Lease along with PricewaterhouseCoopers asked 150 industry experts - developers, investors, brokers, researchers, corporate real estate executives and consultants - what they expect in the year ahead. In its 22nd year, Emerging Trends reveals the forecast for the first year of the new millennium.

Governors at work First and foremost, Emerging Trends claims that "income is king." While there are a handful of high-risk, high-reward opportunities, growth-oriented returns are unrealistic for 2001. Respondents expect unleveraged real estate returns of 11% for the year and edging lower. Revitalized after a tough couple of years, REITs are expected to achieve returns of 12%.

Emerging Trends lists four primary indicators that support its positive forecast:

- Real estate isn't overpriced compared with other assets. Yield expectations stand at 562 basis points above 10-year Treasuries.

- Vacancy rates for all major property types are less than 10%. Hotel occupancy has slipped, but the break-even rate has decreased faster.

- Rents continue to grow steadily, just without the generous spikes of the recent past.

- Construction is under control, especially in the office sector.

Capital constraints are another driver. Public markets, pension fund boards and lenders who remember the late 1980s and early 1990s have a tight grip. Among the key governors:

- The Federal Reserve has cracked down on lax underwriting with one notable exception: some regional banks might be able to cut some slack for their local developers.

- Generally, lenders are requiring developers take at least a 25% equity stake in projects valued at $50 million or more for recourse loans that also require 30% to 50% preleasing.

- Life insurance companies are saddled with risk-based capital requirements and state regulatory oversight.

- Rating agencies and B-piece bond buyers have a heightened influence in the CMBS market and a penchant for kicking out questionable loans in issuers' offerings. The influence of CMBS issuers is expected to heighten, with the level of offerings rebounding to $1 billion per week.

- Scrupulous, discriminating pension fund boards tend to take a more defensive stance.

"Historically, real estate cycles have been led by real estate fundamentals," says Ray D'Ardenne, head of real estate investment operations at Lend Lease. "A supply and demand imbalance would restrict capital flow because the rate of return would drop. This time around, the cycle seems to be more capital-driven than real estate-fundamental driven."

The German investors who swallowed up properties during the past few years are holding off on new investments to "digest" new holdings in their domestic syndication markets, Emerging Trends reports. That leaves large-cap REITs, the major pension fund advisors and a handful of entrepreneurial companies backed by institutional capital in the driver's seat when it comes to large acquisitions.

"The capital out there is significant," reports one Emerging Trends respondent. "There's a huge amount looking for homes, but it's not irrational - it's not being forced."

The tech effect Regarding technology, Emerging Trends hammers home some of the same findings as last year's edition: the need for flexible space for high-tech tenants; poorly located retail and industrial product will suffer; high-tech companies drain the executive talent pool; and apartment and hotels will be least affected. The survey reveals tenants' increased need for power and HVAC in addition to two separate fiber-optic pathways in office buildings to ensure that telecom and data capabilities do not fail.

But Emerging Trends also looks at telecom ventures and business-to-business Internet applications. Tenants will demand access to a wide range of telecom providers, and tenants, not owners, will control the process.

As for B2B applications, respondents expect the Internet and other technology applications eventually to root out some of commercial real estate's deep-seated inefficiencies, standardizing information and practices.

"The inefficiencies have hurt real estate as an investment," one respondent says. "Real estate has been too mysterious, and that turns off investors: How do you buy when you don't have an adequate benchmark? Technology will help change that and make us more understandable and efficient."

For brokers, there's good news and bad news, Emerging Trends notes. High-end brokers that add value to complex leasing and financial negotiations aren't going anywhere, but technology may lead to a thinning of the ranks of mid-level brokers, appraisers, accountants, asset managers and property managers. Smaller firms may feel a pinch as well, as larger firms are better positioned to afford new technology.

Where to go, what to buy Again, Emerging Trends sings the praises of 24-hour cities such as New York, San Francisco, Boston, Washington, D.C., and Chicago. Those cities offer significant barriers to entry, technological infrastructure, improved fiscal health and lower crime, unique neighborhoods, their status as creativity centers and immigration gateways, mass-transit options and lifestyle advantages.

While respondents generally have a tepid view of suburban office, a number of "subcities" made the short list: Buckhead in Atlanta; Reston, Va., and Bethesda, Md., near Washington, D.C.; Bellevue, Wash., near Seattle; Walnut Creek, Calif., outside San Francisco; and Birmingham, Mich., outside Detroit.

Caveats for such areas - both 24-hour cities and, to a degree, the subcities - include poor urban public schools and a lack of affordable housing. Secondary and tertiary cities - those with 9-to-5 downtowns - draw a red flag from those interviewed for Emerging Trends.

In a balanced market where do opportunities lie? Emerging Trends interviewees like adaptive reuse for tech tenants, town center infill developments, condo or apartment development in burgeoning subcities, office development in 24-hour cities (if you can find the land), the capital-starved seniors housing and health care sector (retirement housing more so than nursing homes and medical facilities), and full-service hotels.

One of the report's more interesting findings concerns seniors housing. After too much capital invested too soon in the 1990s, demographics over the next decade favor seniors housing.

"Consider investing in seniors housing because it's definitely on the upturn after the past several years," D'Ardenne says. "Seniors housing is probably at its cyclical low. It's pretty battered. Long-term, I don't think anybody can deny its fundamentals. There are some good, long-term growth prospects."

In the buy, hold, sell category, 62% of interviewees thought industrial properties are a good investment choice, and 67% thought the same of apartments. With an outlook suggesting it's time to get out while you can still salvage something, 71% said it's time to sell limited-service hotels, and 74% felt the same way about power centers. Regional malls (53%) and full-service hotels (54%) led the hold category, with one of the better contrarian plays being the acquisition of full-service hotels in 24-hour markets.

"There's still good relative value to achieve higher yields," D'Ardenne says. "Is it the opportunity fund deals that you were able to get three or four years ago? No, but you're still able to get pretty healthy returns in this market."

D'Ardenne concludes that in terms of fundamentals, the commercial real estate market "really doesn't get any better than this."

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