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Playing it safe

Any forecast of commercial property market trends for 2002 probably warrants a disclaimer — “things are subject to change in the blink of an eye.”

That's about how long it took for life as we know it to be turned upside down on Sept. 11, 2001. Real estate was thrust into the public spotlight like never before. The world watched in horror as millions of square feet of office space came crashing down to earth. Northbrook, Ill.-based Grubb & Ellis estimated 27.5 million sq. ft. was taken off the market, destroyed or damaged in some way. New York-based Cushman & Wakefield reported that 44% of Downtown Manhattan's Class-A office inventory was destroyed or damaged, and thousands of businesses — paying tenants if you will — were left stranded for a time.

Is it too early to talk about rebuilding? With the cleanup of the twin towers and other collapsed buildings expected to take up to a year, there is time for discussion. Two of New York's top developers have weighed in with opposing views on whether the World Trade Center should be rebuilt.

“[Rebuilding the World Trade Center] would be beautiful and symbolic,” said Donald Trump, CEO of New York-based The Trump Organization. “The World Trade Center was never thought of as an architectural gem until just recently. We can do better and make it stronger.”

Mortimer Zuckerman, chairman of Boston Properties, said the city is in for a “rough patch” economically. “This is a tourism town, and we're going into the most important time of the year around the holidays,” he said. “I don't think we should build the 110-story towers. We're talking years and years away, but we do need the office space. It's the logical use for the site going forward.”

Identifying major themes

As we settle into the fourth quarter of 2001, it's only natural to look ahead to what the new year might have in store for the real estate industry. But in doing so, decision-makers realize more than ever that in an uncertain world change can be sudden and dramatic.

It's impossible to say exactly what impact the terrorist acts will have on the nation's commercial real estate markets, but this much is certain from talking to leading experts: the markets will change. There are likely to be long delays, not only at airport ticket counters and security checkpoints, but also among real estate decision-makers who may put off most non-essential investments until the economy stabilizes.

“Nationwide, even robust companies may postpone making real estate decisions. And rather than contemplate a move, many companies may be more inclined to look at renewing leases,” said Steven Bandolik, president and CEO of Transwestern Commercial Services, Chicago. “Therefore, negative absorption will continue in many markets, with other markets exhibiting weak positive absorption.”

How long this rough stretch will last depends largely on the health of the economy. The industry's fortunes are tied to the conditions in business markets, and their prognosis is anything but certain in the wake of the Sept. 11 tragedy.

Why? The nation was already well into recession territory before the attacks. In fact, many economists believe the nation was in a recession by May or June 2001, and many companies are beginning to feel the effects of the downturn. When the 2001 results are tallied in a few months, the airline and hotel industries will be badly damaged by layoffs and reduced business. Through October, airline industry layoffs totaled more than 100,000. A huge drop in hotel occupancies also spurred layoffs, including 10,000 employees at White Plains, N.Y.-based Starwood Hotels & Resorts Worldwide Inc.

The consensus among real estate watchers is that the attacks exacerbated the already slumping economy.

“This is going to plunge the economy a lot deeper into recession, but with the interest rate cuts by the Fed and expansionary monetary policy, it's probably going to pop back a lot faster than what we had expected,” said Marshall Woodward, executive vice president and head of real estate operations at New York-based Lend Lease Real Estate Investments.

The United States' war against terrorism undoubtedly will affect the real estate markets, according to Woodward. “If this gets to be a prolonged military response, it's going to be a real problem for Wall Street and the credit markets,” Woodward said. “Anyone who has to depend on a lot of transaction volume for the end of the year is cooked. We already had bid/ask spread gridlock, especially in the office sector.”

In the short term, Woodward believes the gridlock will worsen before it gets better, but there is hope for a speedy recovery. “We'll probably narrow that spread between buyer and seller now because all the sellers know where we're headed. Before, they didn't,” he said.

Jerrold Barag, Lend Lease CIO, contends that in the wake of Sept. 11, property prices are now more in sync with what bidders are willing to pay. “That in and of itself is a healthy event because it starts to get a market clearing price we haven't had, specifically in office,” he said.

This trend has created a cautionary “wait and see” attitude in financing circles. “If you've got capital, there's going to be a tendency to sit on the sidelines and see what shakes out. You can also expect offshore capital to pull back and observe things,” Woodward said.

Many observers try to draw comparisons to the 1998 global financial crisis that prompted investors to flee CMBS for safer investments such as U.S. Treasury Bills. The capital pipeline also temporarily dried up. However, Woodward said conditions this time around are different. “People were calling up and saying, ‘The deal's off.’ The markets today are in much better shape fundamentally.”

Jacques Gordon, international director of investment strategy at Chicago-based LaSalle Investment Management Inc., a division of Jones Lang LaSalle, summarized the markets this way:

  • Real estate markets started to weaken in late 2000 and early 2001. A recession over the next six to 12 months will accelerate trends already in place.

  • Because the supply pipeline started to slow a few years ago (and is likely to be severely curtailed going forward), the downside for real estate is fairly contained.

  • Office vacancy rates will rise 1% to 3% from today's levels under a typical recessionary scenario. If this happens, vacancy rates would peak at levels significantly below those of 1989 to 1991.

  • Rental rates could fall by up to 10% for office properties, and less for other property types.

  • Long-term income and cash returns will still be attractive, even with moderate rent/income declines over a short-term period.

  • The biggest risk for investors is short-term volatility in the capital markets, which could lead to rising capitalization rates and falling prices. However, cap rates are above their long-term average, so they should bounce back when markets recover.

  • Finally, there is a slight risk that global economic growth will be severely curtailed for an extended period, due in part to concerns about worldwide terrorism. While the real estate industry would suffer in this scenario, it could outperform other asset classes that are more closely tied to the global economy.

With the stock markets feeling an immediate impact after the Sept. 11 attacks, questions have surrounded REIT stocks in particular: Are they still a safe haven, or will they get battered? Ross Smotrich, managing director at New York-based Bear, Stearns and Co. Inc., said REITs should hold up well, and two REIT types in particular are well-positioned for continued success. “If the economy softens further from here, real estate is not immune, and we continue to think that defensive REIT sectors, namely multifamily and industrial, will hold up well,” he said.

Barag said the overall weakness of the economy is going to make bank lenders more cautious than they already were prior to Sept. 11 “just because they're going to be less anxious to be lending in general.” Other financing sources, including insurance companies and institutional investors, will bounce back, “but there's a lot of re-calibration that's got to go on,” Barag said. “Specifically, we're re-analyzing our underwriting assumptions to take into account further deterioration in the economy and how that will ripple through any individual property.”

Specifically, Barag said the biggest issue facing the industry in the short term is the availability of capital. “Liquidity was not good in the real estate markets going into this recession, and it's going to get worse because of the World Trade Center attack,” he said. However, he noted that if cap rates increase because sellers pull back from the market and underwriting standards tighten, “we think in general that real estate is a screaming buy, and we would urge people to look for those signs and get aggressive about committing capital to the sector.”

Thomas Jaekel, managing director of merchant banking at Chicago-based Cohen Financial, said mezzanine lending, also known as gap financing because it reduces the amount of equity an owner must put into a deal, is gaining momentum as investors become more knowledgeable about real estate investments. “We believe capital will continue to flow into the real estate industry. The bottom line is we believe the free markets will prevail,” Jaekel said.

Those same free markets may make lenders more skittish, especially as the downtrodden economy brings more problem loans to the surface. “We will see more foreclosures in 2002 than at any time since the early 1990s,” said James P. Cate, corporate managing director in the Atlanta office of New York-based Julien J. Studley Inc. “All the bad deals that were masked by the good times of the late 1990s will come to the surface. Nevertheless, the difficulties will be nothing like the problems of the 1990 to 1991 recession. It will be less severe,” he predicted.

Mitchell Rudin, executive managing director of Insignia/ESG, New York, is confident that the industry will avoid a crash. “We believe the commercial real estate market in 2002 will resemble availability and asking rents that prevailed in 2001,” Rudin said. “With the technology-sector driven feeding frenzy of 1999 into 2000 and the subsequent return of unused speculative leased space behind us, traditional space users will make prudent decisions about their space requirements.”

Apartments are big winners

Among the five major real estate sectors, the apartment industry appears best poised to meet the many challenges ahead in 2002. According to the authoritative industry survey “Emerging Trends in Real Estate 2002” by New York-based PricewaterhouseCoopers and Lend Lease Real Estate Investments, interviewees peg the multifamily sector as the best investment for the next decade.

“The demand for apartments typically has some cushion even when the economy slows,” said Mark Obrinsky, director of research at the Washington, D.C.-based National Multihousing Council. “In particular, some families and individuals who have been planning to become homeowners tend to postpone that purchase in an uncertain economy and continue to rent.”

Douglas Crocker, CEO of Chicago-based Equity Residential Properties Trust, said apartments make good defensive investments during periods of uncertainty. “Compared to most property types as well as many non-real estate investments, apartments offer very predictable income streams and stable yields, which are desirable attributes when other markets are perceived to be risky.”

Still, a balance between supply and demand is essential for the apartment industry to remain the favored property type. “Even in a strong economy, oversupply can weaken a market due to high vacancies,” Crocker said. “Some of the strongest markets for job growth also saw the most new development, and now that job growth has stalled, those markets may experience intense competition for tenants in the form of rent concessions.” Boston, San Diego and Washington, D.C., will likely be among the strongest market performers in 2002 largely because new development has not outpaced demand for apartments.

Unlike other property sectors, financing for the apartment sector should be available, particularly for development, refinancing and acquisitions. “Financing will be plentiful as long as Fannie Mae and Freddie Mac [loan programs] remain committed to the sector. These two financing sources help set the criteria for solid underwriting,” Crocker said.

Calabasas Hills, Calif.-based ARCS Commercial Mortgage is on course to source at least $3 billion in apartment financing in 2001, and expects to equal, if not exceed, that volume in 2002.

“People are nervous. They don't want to make long-term commitments. It's a flight to liquidity,” said ARCS president and CEO Howard Levine. “Apartments give people flexibility. If they're worried about their jobs, they're certainly not going to plunk down money to invest in a new house.”

Lend Lease's Barag ranks multifamily at the top of the five major property types. “Going into the slowdown, the multifamily sector was in pretty good shape,” he said. “For the most part, apartments should hold up and come out of the weakness better than anything. It's more of a recession-proof sector.”

Obrinsky said it's not just the upscale market that stands to win. “While the upscale sector of the apartment market should continue to grow, the middle market may see even stronger demand,” he said. The mid-priced segment is poised to grow partly because of the slow-growth economy, as well as demographic trends such as the rise in the number of young households and the continued high levels of immigration. Both of those groups are more likely to seek mid-priced apartments, Obrinsky added.

Office holds steady

The New York office market, the largest in the country, was acutely affected by the terrorist attacks. Although many Downtown tenants have been forced to relocate following the destruction of millions of square feet of office space, real estate watchers are optimistic about the long-term prognosis for that market.

“We believe the area around the trade center will be rebuilt, but without the 100-story towers,” said Drew O'Malley, managing director and head of the New York region for New York-based CSFB Realty Corp. “We expect some sort of memorial to be built with 40- to 50-story towers around it.” Given the pledge by Mayor Rudolph Giuliani and President George Bush to rebuild the area, O'Malley expects Downtown to come back as strong as ever and remain the world's financial center.

According to O'Malley, many of the deals for space executed immediately following the Sept. 11 attack were short term, and these leases will need to be converted to long-term deals in 2002. Looking ahead, though, observers wonder if the ripples from the tragedy will spread across the country.

Robert Bach, national director of market analysis at Grubb & Ellis, predicts the nation's office markets will remain weak through the first half of 2002, followed by a slow recovery in the second half. He predicts vacancy rates nationwide will top out at around 14% by mid-2002, not far from the 18% peak in the 1990-1991 recession. “I expect to see a recovery kick in during the second half of 2002 as the construction pipeline empties out and some demand returns to the market,” he said.

Douglas Frye, president and COO of Vancouver-based Colliers Macaulay Nicolls, said the company's forecast — which was reinforced by events in New York City and Washington, D.C. — calls for a gradual recovery in the office sector beginning in 2002.

Meanwhile, Andrew Lechter, managing director in the Atlanta office of Julien J. Studley, said now is a great time to be a tenant. “The economic slowdown which was occurring prior to the attack was causing landlords to adopt a more conservative outlook, and we expect this will continue,” he said. “Large and credit-worthy businesses should take advantage of this slowdown to renegotiate the terms of their leases because landlords are going to be in a mindset to stabilize the values they currently have in place, thinking that adding new tenants is going to be challenging.”

And there appears to be plenty of space available for lease in most markets. That glaring problem of many office markets in 2001 — the sudden oversupply of sublease space — undoubtedly will linger in the coming year.

“The technology, media and telecom sector, which was largely responsible for the run-up in demand for space in 1999 and 2000, will again be largely absent from the market in 2002,” Frye said. “Sublease space will still be a significant factor in 2002 and will mostly likely have a material effect on the market until 2003.”

Tom Thompson, senior vice president and senior underwriter at Houston-based Stewart Title Guaranty Co., agreed that “there is some more sublease burn-off to come.”

Overall, though, the pace of new sublease space being unloaded on the markets is not what it was just six to nine months ago, noted Rich Horn, president of Indianapolis-based Duke Realty Corp. Additionally, some technology companies with significant growth plans have demand for space.

So, how long will the tech space sit around? The bulk of technology sublease space has already hit the market, Frye said. “This space will linger well into 2002, but given a modestly growing economy and sharply lower levels of new construction, most will be released by the end of the year.”

Although the attention on sublease space has largely focused on technology firms, the phenomenon extends into other industries, said Bach. “It is being created by tenants across the economic spectrum. Waves of sublease space will continue to wash over the market through the first half of 2002,” he said.

With an uncertain economic climate ahead, financing will be harder to obtain, and mezzanine lenders could see brisk business. “Financing for property with higher-credit tenants and at or below-market leases will be adequate,” said Frye. “Interest rate spreads will increase to reflect the perceived rise in risks inherent in a softer economy. Mezzanine debt is expected to play a larger role in an effort to bridge the valuation gap between inside equity and outside debt. Seller financing also is expected to increase.”

However, traditional financing sources will be “open for business” in 2002, said Frye. “With real estate fundamentals still strong by historical standards, public and private debt, as well as public and private equity, will remain viable sources of financing,” Frye predicts. “The only concern is pension fund capital, where real estate allocations have risen sharply as stock prices have fallen.” Typically, pension funds allocate 5% to 10% of their portfolios to real estate. As the broader equity markets began to tumble, the value of pention funds' real estate holdings rose inversely. Now, they are considering whether to further increase their holdings in real estate.

All eyes will be on new construction, as developers continue balancing supply with future demand constraints. Bach said net absorption is likely to be negative for the remainder of 2001 and possibly through the first half of next year as tenants react to the weak economy by laying off employees and vacating space.

Given the increased uncertainty and rising financing costs of speculative construction, look for new office starts to drop off substantially in 2002. “Vacancies are increasing, demand is flat or slightly negative and there is also some downsizing yet to occur,” Horn said. “We, like many other developers, will continue to do speculative development on a very selective basis in submarkets that are very strong. Overall, we think that before speculative development returns in a big way, occupancy in existing portfolios will need to rise in a big way.”

Industrial stays industrious

Real estate pros are singing the praises of industrial properties as solid investments these days. Woodward of Lend Lease ranks the industrial sector as a strong second to the front-running apartment sector.

“The volatility in industrial never gets too bad,” Woodward said. “There's a group of about 10 markets that we try to stay in. We've always liked the three big markets — Northern New Jersey, Chicago and the Inland Empire [California]. We would prefer to be there. We're pulling back from markets we might have gone into five years ago.”

But as the nation's economy continues to slow and consumer confidence shrinks, the industrial market feels the pinch from reduced goods flowing in and out of warehouses.

“The blow to consumer confidence will obviously trickle down to the manufacturing and distribution sector,” said Kurt W. Rosene, senior vice president of Chicago-based The Alter Group. “In little more than a week, the attacks cost the struggling U.S. aviation industry nearly 70,000 jobs and billions of dollars in revenues.”

It's important to remember, he added, that the economy was struggling before the Sept. 11 attacks, and the slowdown in the Pacific Rim was impacting the U.S. industrial sector.

Hamid Moghadam, CEO of San Francisco-based AMB Property Corp., pointed out that, contrary to previous trends, companies, distributors and logistics companies will carry more inventory than before. “They will rely on increased inventories in the event of another major disruption due to slowdowns in transportation,” he said.

The air of uncertainty, quite naturally, may lead more tenants to renew their leases because they don't want to make new commitments in this environment. “There will be less build-to-suit activity for the same reason,” Moghadam anticipates.

Greg Gregory, president and CEO of Atlanta-based Industrial Developments International (IDI), is bullish on the sector despite the jitters created by the war on terrorism. “I haven't lived through a war on the United States on our own ground, so I don't know what that means,” he said. “You can think of a lot of negative factors, but you can also think of a lot of positive ways it can factor in. The government and businesses may be spending money.”

One trend that is expected to continue into 2002 is the reconfiguration of supply chains, especially among companies facing consolidation and mergers, said Gary Weiss, senior vice president and national director of integrated industrial solutions at Chicago-based First Industrial Realty Trust.

But John Gates, president and CEO of Chicago-based CenterPoint Properties Trust, said as the economy slows, so does the industrial sector. “Industrial real estate, whether in Chicago or anywhere else, has not been impacted [by the attacks], but it will be if the economy slows down,” he said. “The increase in the number of expansions and locations will diminish even further as the flow of goods in our economy diminishes.”

While capital is plentiful, Gates said many companies are delaying growth plans due to the slow economy. “So you're starting to see the beginnings of pent-up demand, much the way you did in 1992 and 1993, which exploded in 1994, 1995 and 1996,” he said.

Other companies are moving ahead with their decisions after spending most of 2001 in the planning stages, according to Michael Brennan, president and CEO of First Industrial Realty Trust. “We have a significant backlog of demand, and you'll see significantly more absorption come over the next three quarters, and first-quarter 2002 will be better than first quarter 2001,” Brennan predicts.

Retail's slump deepens

Perhaps no other property sector is as tied to consumer spending and confidence as retail. As the economy takes a beating, so does the nation's retail market. The National Retail Federation (NRF) recently revised its fourth-quarter sales growth estimates for general merchandise, apparel, furniture, home furnishings, electronics and appliance stores to 2.2% compared with the previous forecast of 4%. Also, the NRF is predicting 2001 holiday retail sales to increase by an anemic 2.5% to 3%.

Michael Beyard, senior resident fellow of retail and entertainment at the Washington, D.C.-based Urban Land Institute, said the Sept. 11 tragedy is likely to accentuate the slowdown in consumer spending, which is leading to softening rents. “This may speed us to the bottom of an economic cycle that was going to happen in any case, and, as a result, hasten a return to retail spending growth in 2002,” he said.

On a more negative note, Beyard cited some national retail chain stores that have either gone out of business or filed for Chapter 11, including Chicago-based Montgomery Ward & Co. and Rocky Hill, Conn.-based Ames Department Stores. He expects a growing number of marginal independent stores to fold due to declining sales in a sector that's widely perceived to be over-stored. “New retail construction will slow until the national and local economic picture becomes clearer because developers and retailers hate uncertainty,” Beyard said.

What about the all-important holiday shopping season? Here Beyard sounded a more positive note. “I expect to see the best Christmas sales ever in 2001 as retailers desperately try to convince consumers that it is OK to start spending money again and as they also try to recover from declining sales earlier in the year,” he said. “Spending could be helped this fall and winter if depressed consumers start buying to make themselves feel better.”

On the financing front, the lending climate will continue to tighten as money flocks to the strongest retail companies and projects. “Financing will remain available for quality product, primarily projects with a quality anchor tenant,” said Bernard Haddigan, national director of San Francisco-based Marcus & Millichap's national retail group in Atlanta. “Underwriting standards, however, will be tighter and investors will spend more time scrutinizing pro-forma income and cost projections. This variable could result in reduced transaction velocity,” he cautioned.

Investors will show the most demand for single-tenant, net-lease properties occupied by retailers with strong credit, Haddigan predicted. “These properties are often low yield, but they are also relatively low risk,” he said. “Today, triple-net, single-tenant properties are still an attractive investment for individuals who are not looking for immediate high returns.”

Hotels are hit hardest

Following the Sept. 11 attacks, the travel industry — airlines, hotels and convention sectors in particular — suffered a terrible slump. In some respects, the revenue losses will be mitigated by the nine-year run in prosperity for the industry, but the pain will be felt.

“We've issued a blanket ‘wait and see’ on the hotel market because there's too much variability in what the outcome will actually be,” Barag said. “It's fairly clear to us that from a risk-adjusted standpoint, there isn't a return that can justify an investment in a hospitality property.”

Morris Lasky, a 30-year veteran of hotel consulting, spoke in gloom and doom tones. “Before the events of Sept. 11, the hotel industry was experiencing a loss in occupancy and in average daily room rates,” Lasky pointed out. “The impact of Sept. 11, from my point of view, will drive the properties that are borderline over the edge, thus creating problem properties for lenders. What I see is a struggle to exist, if lenders are not helpful.”

Even before the terrorism crisis, the Hospitality Research Group of San Francisco-based PKF Consulting was projecting the most severe decline in performance in 40 years, with estimated revenue per available room (RevPAR) for 2002 predicted to drop even further than the 3.5% decline expected for all of 2001.

John Fox, senior vice president and head of PKF's New York office, cites factors that will cause further difficulties: fear of flying, the down economy, and the drop in demand occurring during the crucial fall and winter months for conventions and winter travel.

Fallout from the struggling hotel industry already is evident — Irving, Texas-based Felcor Lodging Trust and Washington, D.C.-based MeriStar Hospitality Corp. called off their planned $2.7 billion merger in September “due to adverse changes in the financial markets,” according to a joint statement.

The cancellation of that merger is a prime example of the cautious investment climate that dominates the real estate industry today. Investors are waiting for the economy to rebound before making any important decisions. While the apartment sector is the current safe haven, many experts believe the economy will recover by late 2002, followed by a rebound across the other major real estate sectors. (Please see related story on the hotel and office sectors on page 58.)

Ben Johnson is an Atlanta-based writer.

What is the biggest challenge your sector of commercial real estate faces in 2002?

Douglas Crocker II
President & CEO
Equity Residential Properties Trust

“The multifamily sector has enjoyed almost 10 years of unprecedented growth in rents and net operating income. While many markets are in equilibrium, current supply levels coupled with rising unemployment will put stress on a number of markets — most notably Atlanta, Phoenix, Orlando and San Antonio. Rental increases will compress in most markets, and net collections will actually run negative in a number of markets as vacancies and concessions rise. Controlling property level expenses, and cutting corporate overhead while maintaining employee engagement and enthusiasm will be major challenges next year.”

Jacque Ducharme
Julien J. Studley Inc.
New York

“Our biggest challenge for 2002 will be the state of the economy and job growth. It is very unclear exactly what direction the economy will be headed and how it will affect the real estate market. However, we do suspect, that as a result of the events of Sept.

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