Emerging Trends in Real Estate(R) 2005: 'The Race is on Between Improving Fundamentals and Rising Interest Rates'

November 3, 2004

Growing Optimism Over Market Recovery is Tempered by Concerns Over Economy, Job Growth

NEW YORK, /PRNewswire/ -- While real estate investors generally express cautious optimism regarding industry performance in 2005, concerns over the economy and job growth, coupled with the likelihood of higher interest rates, are curbing expectations for a robust year, according to Emerging Trends in Real Estate® 2005, just released by the Urban Land Institute (ULI) and PricewaterhouseCoopers LLP.

At the same time, "interviewees almost without exception are confident that U.S. real estate markets can avoid scenarios that would crater property values," notes the report, which is based on surveys and interviews with more than 500 of the industry's leading authorities, and is considered to be one of the industry's longest-running and most-respected annual investment studies.

Emerging Trends in Real Estate® 2005 anticipates that a key highlight of the coming year will be the race between improving fundamentals (occupancy rates, leasing rates, operating expenses, etc.) and rising interest rates. "Can real estate supply/demand fundamentals improve enough in 2005 and 2006 to offset the potential negative impact of rising interest rates on property values and pricing? Make no mistake, the race is on," says the report. "For 2005, it all comes back to interest rates, the economy and job growth."

The report, being distributed during ULI's annual fall meeting this week in New York City, cites several factors that could impede economic expansion: federal government budget deficits; the balance of trade deficits; the weak dollar; unprecedented levels of consumer debt; inflationary pressures from high oil prices; rising employer healthcare costs; "choppy" job growth prospects; queasiness over terrorism threats; uncertainly surrounding the Iraq War and the possibility of interest rate spikes.

The report notes that most new jobs being created have been concentrated in service industries such as restaurants, temp agencies, retail sales and building services -- niches that "don't fill office buildings or have the earning power to generate growth in other property sectors," says Emerging Trends. Part of the reason is the maturing of America's dominant businesses - - telecommunication, financial services and pharmaceuticals -- which recently have experienced widespread consolidations in order "to squeeze out efficiencies rather than grow new jobs as in the past."

According to the report, many interviewees are looking to health care and biotech to stimulate new job growth, particularly as baby boomers age. Additionally, "advances in high tech should bring the industry out of its bubble-triggered slump," notes Emerging Trends.

While the report points out that Internet technology has greatly reduced the need for office support staff and expensive headquarters space, Emerging Trends also reports that the recent public discussion concerning "offshore outsourcing" is dismissed by many interviewees as "overblown media hype."

In the words of one REIT executive quoted in the report: "The economy is in transition, and offshoring is a moderator of growth. It is not as dismal as the alarmists predict, but it is part of the current lag and may be stalling some of the near-term acceleration."

Emerging Trends survey participants increasingly voiced concern over America's schools and their ability to educate students to adequately compete in a rapidly evolving global economy that places a premium on math and science skills. "We need to do better if we are to maintain our edge and keep creating high-level, high-paying jobs at home," says an interviewee.

Emerging Trends, now in its 26th year, examines the outlook for real estate capital markets and contains a comprehensive annual forecast for all categories of the commercial real estate industry, including apartments, regional malls, downtown offices, warehouses, community shopping centers, suburban offices, research and development space, power centers, full-service hotels and limited-service hotels. This year, the report also tracks trends in the housing industry.

In its "markets to watch" category, Washington, D.C., New York City, southern California and south Florida ranked as the top investment markets. "Big money continues to go bicoastal," says an interviewee. "Middle America is a hard sell ... Smaller markets must make do on local country club money." The top markets, notes the report, all feature international gateways with physical growth barriers, solid economic underpinnings and are magnets for immigrant labor. As for specific characteristics making each favorable, Washington is considered a "government mecca" practically immune to economic downturns; New York remains a world hub for finance and culture; southern California has a strong mix of entertainment, defense and biotechnology industry; and south Florida -- specifically Miami -- is benefiting from both a baby boomer influx and proximity to South and Central America.

"As technology and global capital flows integrate economies and industries across national borders, cities and markets enjoy better prospects if they can link their fortunes to the evolving international growth path," the report says. "The deck is increasingly stacked against a Kansas City, Milwaukee, or Indianapolis, which pale in comparison to American powerhouse markets, but also faces difficulties competing to attract commodity jobs in offshore face- offs against Dublin, Manila or India."

Despite having expanding populations, Dallas, Houston and Atlanta lose support among investors, due to unrestrained development and poor growth management, Emerging Trends says, noting that the desire to avoid long traffic commutes gives an advantage to markets with mass transportation networks. In general, the success and resilience of the most attractive investment locations can be attributed to 24-hour market characteristics such as upscale infill neighborhoods near commercial districts, convenient pedestrian-friendly retail, ample recreational and cultural amenities and ample transit options, the report says.

For 2005, survey respondents predict that real estate will outperform stocks (67 percent said yes, 33 percent, no) and bonds (96 percent, yes, 4 percent, no.) They also forecast that private real estate has the best asset class investment potential, ahead of domestic stocks and public real estate. In the worst case, should the economy tank from a geopolitical crisis or terrorist attack, interviewees do not believe that property markets will suffer a greater decline than stocks or bonds.

Regarding development opportunities, the report notes that although commercial construction could pick up from this year's dormant levels, prospects remain restrained. "Until markets achieve better supply/demand balance, investors are more focused on buying land, gaining entitlements, and planning projects rather than funding construction," Emerging Trends says. The outlook for housing development, however, remains far more promising, with infill and in town housing again topping the survey development scorecards. While the move back downtown by empty nesters and childless professionals "cannot be ignored," demand should hold steady for suburban single-family housing "as long as interest rates remain manageable," the report says. "Master planned and new urbanist communities tap into rising homeowner demand for neighborhoods featuring more integrated land uses and access to convenient amenities. People seem willing to pay premiums for better planning."

Other Emerging Trends highlights:

  • Retail -- Strength: Consumer spending has been mind boggling,
    bolstering "strong credit" retailers that fill malls and power centers
    ... Shoppers have been "using their homes as giant ATMs." Weakness:
    Real estate investment trusts corner the market on regional centers and
    make inroads at better grocery-anchored portfolios ... Good buying
    opportunities are "few and far between." Best bet: Hold the 200 or so
    fortress malls. Owners with small mall portfolios should take the
    opportunity to sell out or joint venture with a REIT powerhouse.
    Outlook: (Consumers) may need to take a breather in 2005 ... -- A
    modest economic expansion may not offset maxed-out (consumer) credit
    and higher gas and heating bills.
  • Industrial -- Strength: A strong income play and relatively safe bet,
    warehouse investments look like long-term bonds with excellent risk-
    adjusted returns. Weakness: To buy meaningful portfolios, you must take
    lemons with the cherries. Just-in-time technologies continue to erode
    viability of "old school" warehouse space. Best bet: Acquire or hold
    new, higher-ceiling space ... Concentrate on coastal intermodal
    markets. Outlook: Vacancy rates for warehouses remain stubbornly high
    for the sector, but will edge below 10 percent in 2005. As for research
    and development space, 2005 may be a good year to rummage through the
    tech-wreck remains.
  • Apartments -- Strength: Higher mortgage rates hearten multifamily
    investors: would-be homebuyers may keep renting ... Baby boomers' kids
    are starting to graduate from college and marry later, giving a 10-year
    window of opportunity. Weakness: Just say "no" for the next two years
    ... New construction has not slowed since the early 1990s recession.
    Property values may flatten. Best bet: Focus multifamily acquisitions
    on class B and C apartments in high-cost housing markets with ample
    demand from permanent renters: southern California, San Francisco, the
    Northeast and Chicago. Outlook: Apartments will come back, "but not
    real fast." But for the longer term, "apartments make a good defensive
    play -- demographics and interest rates provide a tailwind."
  • Office -- Strength: Companies have either subleased or absorbed a
    majority of the phantom (unused) space, which has boosted occupancies.
    Now tenants can fill vacant space as the economy picks up. Weakness:
    Suburban office space drowns in high vacancies. "Owners pray for a
    quick economic burst, but job growth questions furrow brows and test
    recovery forecasts." Best bet: In Sunbelt meccas like Dallas, Atlanta,
    Denver and Phoenix, "it's time to buy cheap, capitalize cheap and
    figure out what to do with it later." Outlook: Owners hope for a repeat
    of 2004 -- values hold and tenant activity keeps improving.
  • Hotels -- Strength: Leisure travel escalates to record levels, and
    business travel bounces back. Weakness: Many owners deferred
    maintenance in the post 9-11 slide. Some revenue gains must be spent on
    sprucing up rooms and public space. Best bet: The good "fly-to" markets
    -- San Francisco, Boston, New York -- offer the most solid
    opportunities in full-service categories. Outlook: Hotels should
    outperform other property sectors with a two or three-year run of
    advances in net operating income, before new supply starts competing.
  • Housing -- Strength: As long as interest rates stay reasonably low,
    more Americans can buy starter homes, upgrade, or purchase vacation
    properties. Weakness: Some owners, squeezed by higher healthcare costs,
    flat wage gains and higher interest rates, could be vulnerable to
    default. Best bet: The leisure and second-home market has legs.
    Outlook: If mortgage rates rise too far too fast, the housing bubble
    deflates. Home values may level off for a while.

Source: The Urban Land Institute / PricewaterhouseCoopers LLP

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