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Urban LandInstitute$

2006

Real Estate®

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EmergingTrends

Real Estate®

EmergingTrends

Real Estate®

in

2006Contents

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Executive Summary and Preface

Chapter 1 As Long as Capital Keeps Flowing,Everything Will Be All Right

Is Buyer Fatigue Around the Corner?Moderate Economic Growth, with Some IssuesReal Estate Climate Remains FavorableBest Bets 2006Outlook Through 2010

Chapter 2 Real Estate Capital FlowsIs the End Near for Unrestrained Capital Flows?Private Investors and SyndicatorsPension FundsREITsForeign InvestorsBanks and InsurersCMBSMezzanine Investors

Chapter 3 Markets to WatchCoastal Cities Still Preferred, but Foraging IncreasesMajor Market ReviewSmaller Market Prospects

Chapter 4 Property Types in Perspective Hotels, Warehouses, and Niche Sectors on TopDevelopment Gearing UpHotelsIndustrialApartments Office Retail HousingNiche Sectors

Interviewees

ii Emerging Trends in Real Estate® 2006

Editorial Leadership TeamEmerging Trends ChairsPatrick R. Leardo, PricewaterhouseCoopersRichard M. Rosan, Urban Land Institute

Author/EditorJonathan D. Miller

Principal Researchers and AdvisersStephen Blank, Urban Land InstitutePeter F. Korpacz, PricewaterhouseCoopersSteven P. Laposa, PricewaterhouseCoopersDean Schwanke, Urban Land Institute

Senior Adviser and PublisherRachelle L. Levitt, Urban Land Institute

Senior AdvisersWilliam Croteau, PricewaterhouseCoopersRobert K. Ruggles III, PricewaterhouseCoopers

Contributing ResearchersRichard Wincott, PricewaterhouseCoopersSusan M. Smith, PricewaterhouseCoopersRichard Kalvoda, PricewaterhouseCoopers John Rea, PricewaterhouseCoopers

Editorial and Production Staff Bernadette T. Korpacz, Administrative CoordinatorClara Meesarapu, Administrative CoordinatorKarrie Underwood, Administrative CoordinatorNicole Witenstein, Data ManagerNancy H. Stewart, Managing EditorDavid James Rose, Manuscript EditorByron Holly, Senior Graphic DesignerCraig Chapman, Director of Publishing Operations

Emerging Trends in Real Estate is a registered trademark ofPricewaterhouseCoopers LLP.

© October 2005 by ULI–the Urban Land Institute andPricewaterhouseCoopers LLP.

Printed in the United States of America. All rights reserved. No part ofthis book may be reproduced in any form or by any means, electronicor mechanical, including photocopying and recording, or by any infor-mation storage and retrieval system, without written permission of thepublisher.

Recommended bibliographic listing:ULI–the Urban Land Institute and PricewaterhouseCoopers LLP.Emerging Trends in Real Estate 2006. Washington, D.C.: ULI–the Urban Land Institute.

ULI Catalog Number: E23ISBN: 978-0-87420-948-8

Emerging Trends in Real Estate® is a trends and forecast publicationnow in its 27th edition, and is the most highly regarded andwidely read forecast report in the real estate industry. EmergingTrends in Real Estate® 2006, undertaken jointly by ULI andPricewaterhouseCoopers, provides an outlook on U.S. investmentand development trends, real estate finance and capital markets,property sectors, metropolitan areas, and other real estate issues.

Emerging Trends in Real Estate® 2006 represents a consensusoutlook for the future and reflects the views of over 400 individu-als who completed surveys or were interviewed as a part of theresearch process for this report. Interviewees and survey partici-pants represent a wide range of industry experts—investors, devel-opers, property companies, lenders, brokers, and consultants. ULIand PricewaterhouseCoopers researchers personally interviewedover 170 individuals (see the end of this report for a list of thoseinterviewed) and survey responses were received from 303 individ-uals, broken down as follows:

Emerging Trends in Real Estate® 2006 1

■ In 2006, real estate markets reach a pricing peak, cap rate com-pression ends, and performance ratchets down as value gains leveloff. The year promises to usher in a period of acceptable, but rela-tively lackluster returns for property investment portfolios. Sellersdo better than buyers.

■ Cushioning markets against correction, still-ample capital flowsbecome more restrained by year-end as buyer demand turns lessfrenzied and more rational. Real estate should retain its relativevalue edge over stocks and bonds.

■ Modest property cash flow improvements from rising occupan-cies in most property sectors will help offset any increases in caprates, with interest rates expected to advance. Full-service hotelsrank as the favored property type. Technology and corporate pro-ductivity initiatives, including outsourcing, continue to dampenoffice demand growth. Demographics and high housing costs favormoderate-income apartments. Industrial warehouses continue torebound, tracking moderate economic growth.

■ Pressuring net operating incomes, higher energy costs will boostlandlord expenses and could affect consumer appetites and travelbudgets, potentially hurting retail sales and curbing some recentlodging gains.

■ Pricing above replacement cost for existing real estate mayencourage a round of unnecessary development and threatensteady progress toward supply/demand balance in many marketsby 2007 or 2008. Rising construction expenses, however, coulddampen developer enthusiasm and extend the ongoing recovery.

■ The surge in house prices ends and condominium conversionmania hits the wall thanks to rising mortgage rates. Select over-

heated markets may deflate, but values just flatten in most areas.Homebuilder profit margins decline as costs skyrocket for con-struction materials.

■ Public capital markets’ influence over real estate grows. REITstock prices may correct after soaring gains, but these public com-panies will continue to expand market share of owned equity realestate. CMBS offerings proliferate, too, extending into more inter-national markets. Pension funds remain poised to pick up some ofthe investment slack if private investors begin to pull back. Foreigninvestors continue to gravitate to the United States, looking forstability, while American capital moves offshore, especially to Asia,seeking more opportunistic returns.

■ Investors favor coastal markets on global pathways with barriersto entry: southern California; Washington, D.C.; and New Yorktop the survey again. San Francisco rallies. Phoenix ranks as top hotgrowth market. Condominium overbuilding hurts otherwise-solidMiami. Prospects for other Sunbelt agglomerations improve onlymarginally. Chronic market softness dims interviewee outlooks. TheMidwest struggles for relevancy in the face of economic decline.

■ Infill areas—near central business districts and suburbannodes—will become magnets for increased residential and mixed-use development as people look for greater lifestyle convenience in24-hour environments.

■ Investors will continue to scavenge for opportunities in moreniche property categories—seniors’ and student housing, medicaloffice, public storage—as long as core categories seem overpriced.

Executive Summary

Preface32.8% Private Commercial/Multifamily Property Companies

or Developers

16.9% Institutional/Equity Investors or Advisers

13.9% Real Estate Service Firms

9.9% Lenders or Mortgage Bankers/Brokers

9.6% Publicly Traded Commercial/Multifamily REITs orOperating Companies

8.6% Homebuilders or Residential Land Developers

8.3% Other

To all who helped via surveys or interviews, PricewaterhouseCoopersand the Urban Land Institute extend sincere thanks for sharingvaluable time and expertise. Without the involvement of these manyindividuals, this report would not have been possible.

CapitalAs Long as As Long as

Capital

“We are in the eighth or

ninth inning of this [real estate

investment] cycle with a chance to go

extra innings. No one can say with a

straight face that we are early in the

ballgame anymore.”

After an “extremely” lengthy decade-plus cyclical upturn,with the last few years juiced by a healthy dose ofrecord-low interest rates, the U.S. commercial and mul-

tifamily real estate markets appear to reach a pricing peak, andinvestment returns will ratchet down during 2006 in a slow butsteady reversion toward the mean. Cap rate–driven appreciationis ending and investors must depend on increased propertyincome streams to hold or push up values. Despite improvingmarket fundamentals and continuing capital infatuation withreal estate, Emerging Trends’ interviewees signal cautionthroughout this year’s survey over a looming transition to aperiod of more measured, possibly lackluster, performance.While appreciation plateaus, “the price per pound stays at loftylevels,” rents may catch up nominally, but rising short-terminterest rates and inflationary costs cut into performance. “Thebig dollars have been made from cap rate compression, [some]real estate is trading well above replacement cost, and pricing isahead of where it should be at this point in the cycle.”


The consensus forecast, however, suggests that real estatecan maintain a relative value edge over stocks and bonds, atleast in the near term. Real estate’s improved transparency, runof excellent performance, and restored status as a significantasset class alongside stocks and bonds reinforce the majorityview that the risk premium for property investments has beenreduced, enhancing stability and capital liquidity and limitingthe chances for investment losses.

Is Buyer Fatigue Around the Corner?In fact, “lowered expectations” among interviewees for 2006 donot translate into “anything dramatic” or “dire.” The currentflood of available capital in both the equity and debt marketswill sustain substantial investment demand and prop up values

c h a p t e r 1

Keeps Flowing,Everything Will Be All Right

through the year. “Capital won’t dry up suddenly, so there willbe no radical declines.” “The shear amount of equity cushionsthe market in the near term.” Most property sectors should reg-ister improved occupancies and some rent growth, althoughadvances may be spotty across markets. Expect capital to beginbacking off during the second half of the year as a touch ofbuyer fatigue finally sets in over interest rate advances, possiblecap rate erosion, and even heightened development. Concernsabout an ebbing housing market may also create doubts aboutcommercial real estate, especially if some condominium mar-kets show marked declines, as anticipated.

Signs abound of a cyclical pricing crest in Emerging Trendssurvey results and interviews:

Sell Warnings. The sentiment for selling properties overbuying widens further over last year to the largest gap in thesurvey’s history. Not only does the sell rating advance to arecord high for any category on the Emerging Trends transactionbarometer, but also the buy rating drops to its all-time nadir(see Exhibit 1-1).

Foraging Beyond Core. Wary of future return implicationsfrom stratospheric pricing, many investors increasingly shyaway from core property sectors—apartment, office, retail, andindustrial—and consider alternatives. Hotels suddenly zoom tothe top of property rankings and appetites grow for largelyignored niche categories like seniors’ housing, master-plannedcommunities, urban mixed use, resort hotels, and student hous-ing. These segments, in fact, score higher investment ratings for2006 than any of the traditional property sectors. Self-storageproperties and medical office buildings have never been on theradar screens of core real estate portfolio managers until today.Now, the surging demand for niche pickings suddenly has madethem anything but cheap. “Postcard” A-list properties in tertiarycities also see pricing escalate to levels more appropriate to primebuildings in major markets where presumed greater liquiditycommands lower risk premiums. “Everything is overheated.”

Unrestrained Capital. Enduring disappointment overstock market returns continues to push capital in search of yieldto income-producing real estate, which has “never been pricedat such a high premium” to Wall Street equities. Current prop-erty cap rates anticipate substantial rebounds in future revenuesthat may be unrealistic in slowly recovering markets and a ris-ing interest rate environment. Overwhelmingly, more than 80percent of survey respondents view the real estate capital equityand debt markets as oversupplied, and almost 55 percent char-

4 Emerging Trends in Real Estate® 2006

Many investors increasingly shy away from core property sectors and consider

Emerging Trends Barometer: 2006

Buy Hold Sell

4.56

6.378.24

Buy/sell/hold rating prospects on a 0-to-10 (abysmal-to-outstanding) scale.

Exhibit 1-1

5 = fair, 6 = modestly good, 7 = good, 8 = very good.

Source: Emerging Trends in Real Estate 2006 survey.

-9%

-6%

-3%

0%

3%

6%

9%

12%

15%

Spread

'05Q2 '02'00'98'96'94'92'90'88'86'84'82'80'78-9%

-6%

-3%

0%

3%

6%

9%

12%

15% Ten-Year Treasury Yields

Cap Rate

'05Q2 '02'00'98'96'94'92'90'88'86'84'82'80'78

Exhibit 1-2 NCREIF Cap Rates vs. Ten-YearTreasury Yields

Sources: National Council of Real Estate Investment Fiduciaries, FederalReserve, Economy.com, PricewaterhouseCoopers.

Historical Average7.89%

acterize the equity markets as “substantially oversupplied.” Areal estate veteran calls the capital frenzy “unprecedented,”comparable only to the late 1980s’ “orgy” when Japaneseinvestors bid up trophy office buildings and institutionalinvestors drove down regional mall cap rates to sub–5 percentlevels. It all ended badly in a market collapse. So far, the majordifferences today are restrained development (except in condo-miniums) and a lack of attractive investment alternatives. Inaddition, spreads between cap rates and Treasury bills continueto provide investors with a decent though shrinking risk cush-ion (see Exhibit 1-2). But when “money chases deals, under-writing suffers.”

Condo Craze. Only select condominium markets show signsof significant overbuilding nationally. Lenders and rising con-struction costs have helped constrain development in otherproperty categories, giving a chance for most sectors and mar-kets to edge toward better supply/tenant demand balance. Still,“unrestrained condo activity has always signaled the top of the[real estate] market,” says a well-known researcher, and raisesyellow flags “about additional market excess.” Condo-maniaand construction, stoked by speculative buyers, threaten tounhinge multifamily markets in south Florida, Las Vegas, andparts of southern California. Signs of potential residential over-building and slackening buyer demand extend into Chicago,Atlanta, Phoenix, New York, and other metropolitan areas.

Development Dangers. The industry needs to monitorthe supply side carefully for potential harm from overbuilding.“Timing is awfully ripe for a ramp up in new construction.”Lowered cap rates make it cheaper to build new office, indus-trial, and retail projects than to buy existing product. Hotelsalso are poised for another development spurt. “So far, mostdevelopment has not been justified by rents.” But increasingoccupancies and operating revenues may be enough to encour-age skeptical money sources to fund new construction in allcategories. If traditional lenders hold their discipline, hedgefunds, opportunity funds, and real estate investment trusts(REITs) are cash flush and could fill the financing void, lookingto boost their lowering return prospects. In slow-demand mar-kets like Chicago and Philadelphia, new marquee office build-ings already steal away local tenants, increasing overall vacancy.Chronically oversupplied Atlanta and Dallas resume office con-

struction despite mediocre growth forecasts and empty build-ings. Unnecessary development could upend some marketscreeping toward equilibrium. “We may do ourselves in.” On apositive note, high land and increasing construction costs couldact as an indispensable governor, discouraging some projects.Rebuilding the Gulf Coast and New Orleans in the aftermathof Hurricane Katrina will siphon off supplies and materials,hiking costs further and leading to shortages.

Housing “Bubblettes.” Many interviewees express concernthat “unsustainable” housing prices will deflate, at least in somemarkets. Rising mortgage rates and tightening lending stan-dards finally will put current nosebleed price points out ofreach for increasing numbers of buyers and dash speculatoractivity. Some cash-strapped borrowers using floating-rate debtmay get squeezed out of their homes as defaults increase. Whenthe public realizes “beanstalks no longer grow to the sky,” nega-tive press could chill enthusiasm for real estate in general. Many“people in single-family America are extended beyond theirmeans and it is the single-family homeowner/consumer thatruns America.” Shopping centers could feel an extra sting—retail buying has been fueled by new homeowners “needingstuff ” to fill rooms and closets, and by existing owners, whohave refinanced mortgages to buy “more things.” As many mar-kets continue to create households faster than they build newhomes, demand for housing will not dry up, but may flatten.

Less Heady Returns. Performance expectations edge downacross all investment categories compared with last year’s survey.“There’s no pop left.” Anticipated unleveraged total corereturns drop below 8 percent—“more like a bond.” The higher-risk value-add segment levels off close to 12 percent, andopportunistic returns dip below 15 percent (see Exhibit 1-3).What happened to 20 percent–plus? Most advisers claim theystill can achieve such gains, but only if they invest outside theUnited States, particularly in Asia. Performance may head stilllower in 2007 as cap rates advance. But sustained healthy capi-tal flows, absent some unforeseen event shock, protect real


alternatives.

estate from a correction. Forecast revenue growth should alsobuttress values for most properties. Given real estate’s loweredrisk profile and improving fundamentals, these returns remainsolid, albeit “on the low side.”

“Everything Hangs on Interest Rates.” No one disputesthat low interest rates extended this real estate cycle (12 yearsand counting), which had showed signs of deteriorating afterthe 2000–2001 high-tech/telecom industry implosion, a situa-tion that was exacerbated by 9/11. Low mortgage rates pro-tected owners from defaults when rents and occupanciesdeclined and buyers could enhance returns to heady levels by effortlessly leveraging up properties on inexpensive debt.Investors poured into the markets to take advantage. Cap ratesplunged and appreciation soared despite tepid tenant demandand mediocre revenue growth in all sectors except consumer-driven retail. Owners and investors “hit the trifecta—cheapmoney, plentiful capital, and increasing values.” Intervieweesnow reluctantly accept that “Nirvana is over” and forecast mod-erate increases for both short- and long-term rates in 2006 aswell as over the next five years (see Exhibit 1-4). “Interest ratesare the fly in the ointment.” “They have nowhere to go butup.” The higher rates go, the more likely some capital will grav-


A majority of interviewees predicts that sustained market liquidity will moderate any cap rate advances.

2005 2006

Exhibit 1-3 Total Expected Returns for U.S. RealEstate Investments in 2005 and 2006


Opportunistic Real Estate Investments

Value-Added Real Estate Investments

Core Real Estate Investments (leveraged)

CMBS (unrated)

Core Real Estate Investments (unleveraged)

CMBS-BBB-rated (lowest investment grade)

Publicly Traded REITs and Operating Companies

Commercial Mortgages (whole loans)

CMBS-AAA-rated (highest-rated)

14.27%

14.38%

12.44%

12.30%

10.68%

10.82%

9.26%

9.14%

7.85%

7.89%

7.29%

7.06%

7.20%

7.81%

6.51%

6.22%

5.41%

5.21%

0 1 2 3 4 5

Over the Next Five YearsThrough 2006

Exhibit 1-4 Inflation and Interest Rate Changes

1 = fall substantially, 2 = fall moderately, 3 = remain stable at currentlevels, 4 = increase moderately, 5 = increase substantially.


Short-Term Rates (one-year Treasuries)

Commercial Mortgage Rates

Long-Term Rates (ten-year Treasuries)

Inflation

itate away from property markets to bonds and other fixed-income instruments, exerting upward pressure on real estate caprates and reversing some recent value gains. More expensiveleverage, meanwhile, will impinge on various “easy money”financing strategies.

The Race Continues. If interest rates advance in 2006 as sur-vey respondents expect, investors will count on improving occu-pancies and rental rates to increase net operating incomes andhelp offset any cap rate rises. This race between interest rates,fundamentals, and cap rate changes, detailed in last year’s report,has so far been turtle paced, with fundamentals gaining a slightedge. The Fed’s quarter-point advances have coaxed short-termrates higher, but the long bond has lagged and cap rates havejogged to record lows thanks to those prodigious capital flows.Modest property cash flow improvements leave NOIs only “mar-ginally better than three years ago.” Apartment rents increased in2005, but most office and industrial market vacancies will notdecrease enough to push rents until 2006 or later in some mar-kets. At least concessions are declining. Retail property ownersgrow concerned about how inflated energy costs and uncomfort-able household debt levels eat into consumer appetites. Onlyhotels rebound robustly. Higher utility and heating bills will raiselandlord expenses and chew at property cash flows.

Relative Value Holds Sway. A majority of intervieweespredicts that sustained market liquidity will moderate any caprate advances, and those increases will not be on a one-for-onebasis with interest rates. “Real estate will remain a loved asset

class and remains reasonably priced compared to stock andbond alternatives.” Certainly, property investments comparefavorably to the securities market over the past ten years (seeExhibit 1-6). Add improving fundamentals to lower risk premi-ums and values can remain stable as interest rates increase fur-ther. All bets are off, however, if the stock market suddenlygets hot or interest rates spike and the bond market takes off.Interviewees express confidence that won’t happen in 2006 (seeExhibit 1-7). Still, an underlying discomfort exists over recentpricing, “artificially increased” by cap rate compression and dis-connected from market realities. Positives in cash flows havenot been enough “to bail out a [cap rate] reversal.” While somereal estate pros think the real estate markets are overpriced, thecapital markets think differently for now and prices have keptgoing up. And given low bond yields and high price-earningsratios for equities in recent years, there is some rationality tolower cap rates from a relative value point of view (see Exhibit1-8). But many real estate veterans are skeptical about currentlow cap rates. “You cannot rationally accept that this is a six-cap world. The opportunity going forward is in yield, notmuch if any in appreciation.”

As long as capital keeps flowing, everything will be all right.


any cap rate advances.

-5%

0%

5%

10%

15%

20%

Spread Between Ten-Year and 91-Day

-5%

0%

5%

10%

15%

20%

91-Day TreasuriesTen-Year TreasuriesFed Funds Rate

‘05‘04‘02‘00‘98‘96‘94‘92‘90‘88‘86‘84‘82‘80‘78

Exhibit 1-5 Interest Rates and Spreads

Sources: Economy.com, Federal Reserve Board, PricewaterhouseCoopers.

-30

-20

-10

0

10

20

30

40

Lehman Government Bond

NAREIT NCREIFS&P 500

‘04‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘91‘90

Exhibit 1-6 Returns: Real Estate vs. Stocks/Bonds

Sources: National Council of Real Estate Investment Fiduciaries,Standard & Poor’s, NAREIT.

Perc

ent

Moderate Economic Growth,With Some Issues“I’m optimistically confused. All indicators look right, but itdoesn’t feel right.”

Four years into economic recovery, the Emerging Trends con-sensus expects moderate growth to continue through 2006, sup-porting improved real estate demand metrics, but not generatingprolific gains. The consensus forecasts from leading economistssuggests GDP growth of around 3.3 or 3.4 percent for 2006,

and most in our survey seem to agree, expecting the economy tokeep moving forward as it has been at a moderate pace:

“Healthy, but not robust.”“Pretty good, but not great.”“No recession on the horizon.”“Disappointed, but optimistic.”“Moving at three-quarters speed.”“Expansion has been at a sub-par rate, but there is still somegas left.”“Regardless of how you think we are doing, the U.S. is stillthe world leader.”

Though hopeful, many interviewees remain stumped tryingto identify new growth engines to replace dwindling manufac-turing industries and pump life back into high tech. Othersare encouraged by the economy’s moderate expansion across awider range of sectors, resulting in growth that could be morestable and sustainable. A number of issues bear watching as2006 unfolds.

Consumers and Housing. Consumer buying and housingdemand have been the bedrock of the ongoing economic recov-ery. Both look a little “long in the tooth.” The refinancing wavehas run its course as interest rates move up. Can house pricesgo much higher when mortgage rates increase? Rising energycosts may subdue buying power, and wage gains will need to


The Emerging Trends consensus expects moderate growth to continue through

0%

3%

6%

9%

12%

15% S&P Inverse P/E Ratio

Cap Rate

‘05Q2 ‘02‘00‘98‘96‘94‘92‘90‘88‘86‘84‘82‘80‘78

Exhibit 1-8 NCREIF Capitalization Rates vs. S&P500 Inverse P/E Ratios

Sources: National Council of Real Estate Investment Fiduciaries,Standard & Poor’s.

0Abysmal

5Fair

10Outstanding

Exhibit 1-7 Investment Prospects for VariousAsset Classes in 2006


Note: Prospects were rated on a total rate of return basis.

Asian Private Direct RealEstate Investments

U.S. Private Direct RealEstate Investments

International Equities

European Private Direct RealEstate Investments

U.S. Publicly Traded REITsand Operating Companies

U.S. Publicly TradedHomebuilders

U.S. Equities

U.S. Commercial Mortgage–Backed Securities

U.S. High-Yield Bonds

U.S. Investment-Grade Bonds

U.S. Money Market Funds

accelerate (see below). “The consumer is the big question mark.Can consumers keep spending, especially with rising energycosts? We’re on the cusp.”

Job Growth. If you take away all the jobs generated by therecent housing boom—construction workers, laborers, mortgagebrokers, real estate agents, architects—the nation’s employmentgrowth would look more modest. “It’s scary that we’ve made noprogress in establishing a new jobs generator in the U.S.” Atleast the pace of job growth has kept slightly ahead of the num-bers of new workers entering the labor force, and the economyremains broadly diversified. Aside from real estate, the mostactive labor sectors have been health care (increasing babyboomer ailments), professional services (lawyers and account-ants, thanks partly to Sarbanes-Oxley), leisure and hospitality(hotels are back!), and trucking (all those imports). Wage growthhas also languished for moderate to low earners, barely keepingahead of inflation, and household incomes have remained rela-tively flat over the past several years. But low unemploymentcombined with continued hiring eventually could start pressur-ing wages in the right direction to support continued consumerspending. Recent employment gains have been enough to spurincreasing apartment rentals—room-mating declines and youngadults move out of their parents’ homes as they find more work.The hurricane catastrophes eventually will encourage super-charged employment growth around reconstruction in the GulfCoast area, but not long-term office jobs.

Relentless Corporate Productivity Gains. Solid corpo-rate earnings have translated into only moderate hiring in officejobs, and profits continue to derive from relentless cost cutting,“productivity increases”—including working employees longerand harder—and managing space costs, all of which has kept alid on office absorption. Rising health care and benefits expen-ditures check company budgets for new full-time hires. Cubiclelife becomes the accepted norm. “Companies are laser-focusedon overheads—there’s just no letup in trying to reduce occu-pancy expenses,” says a corporate real estate adviser. No wonderoffice occupancy rates crawl up so slowly, except in the topdemand markets. Technology advances promise to offer newstrategies for further reducing square footage per employee.Next-generation gizmos will enhance worker hoteling andenable more outsourcing, including hiring more freelancerswho can operate from home. Over the next five years, manycompanies will give workers laptops configured with wirelessphones and Internet access that function almost anywhere.

“You show up at the office when you need to, it almost doesn’tmatter where you sit—your E-mail and phone calls will followyou wherever you go, and you have access to all your computerfiles without plugging in.” Graybeards may grumble about theirlost windowed office, but for the younger wired crowd it allmakes sense along with the paycheck. Building owners face themusic—demand growth for office space will likely not riseaggressively as it did in the 1990s.

The Offshoring Reality. Most interviewees now acceptthat offshore outsourcing has become “a fact of life” and a partof corporate strategies, affecting job growth and office demand,at least on the margins. Survey respondents rated the issue asone of “moderate importance.” Many interviewees expressedconcern. “It’s a big deal and growing,” “a significant trend withno letup in sight.” “Every knowledge-based job is vulnerable.”“It’s not just call centers and lower-skilled back office.” Thebusiness economies are simple: Internet technology allows U.S.companies with the highest-paid workers in the world to trans-mit assignments overseas to well-educated workforces, operatingin substantially lower-cost (wage, benefits, space) markets.“Work is exploding with U.S. corporate clients in China andIndia,” says a property management consultant. U.S. developers


2006, supporting improved real estate demand metrics, but not generating prolific gains.

-20-15-10-505

101520253035

40%

NAREIT Total Returns

GDP GrowthNCREIF Total Returns

‘05* ‘03 ‘01 ‘99 ‘97 ‘95 ‘93 ‘91 ‘89 ‘87 ‘85 ‘83

Exhibit 1-9 Real Estate Returns and Econimic Growth

Sources: U.S. Department of Commerce, Economy.com, National Councilof Real Estate Investment Fiduciaries, NAREIT.

*2005 GDP data are projected; 2005 NCREIF data are annualized for theyear ending in the second quarter of 2005; 2005 NAREIT data are year-to-date as of September 30.

and investors also eyeball Asian opportunities to build out spaceto house all the activity. “Now you can move work around theworld over 24 hours to get it completed—it’s slick and effi-cient.” Beyond the near-term impacts on office demand, off-shoring threatens to reduce U.S. wage rates to allow Americanworkers to compete globally. It has happened in the manufactur-ing sector (China and South Korea); it’s now happening in someservice industries. America needs to start producing that newer

and better mousetrap to stay ahead. Some respondents hold aless pessimistic view of offshoring. They rightly point out thatglobalization will lead to more economic growth worldwide andmore international tenants locating in U.S. markets. Coastalgateway cities should benefit especially.

Inflation and Recession Threats. Rising costs for concrete,steel, wood, and other construction materials lead some inter-viewees to warn that inflation may be making a comeback.Rising construction costs, and inflation in general, were top-rated concerns among survey respondents (see Exhibit 1-10).Housing prices, of course, have shot through the roof and gaspump shock naturally augments concerns. Katrina and Ritaunleashed a one-two punch—pushing up both energy and mate-rial costs. Transportation prices march upward—anything thatmoves by truck costs more, including most retail goods. Andwhat happens this winter when heating oil and natural gas billsarrive? Consumers may finally tap out and cut back on shoppingsprees. Hoteliers worry that airline fuel expenses could escalatefares and short-circuit some business and tourist travel. Energyprices tend to be highly volatile, but a sudden rollback isn’t agiven as long as Iraq smolders. China’s thirsty industrial enginevies for more oil, as its growing middle-class population trades inbicycles for cars, while the United States is hamstrung by underca-pacity in its refineries. Inflationary pressures could force the handof the Federal Reserve to raise the funds rate faster or higher overa longer period than currently anticipated. Aside from their infla-tionary profile, energy cost spikes also can upset the economy,having helped precipitate recessions in 1973 (Arab oil embargo),1979/1980 (Iran hostage crisis), and 1991 (Gulf War).

Oil, Sprawl, and Housing. No longer a leading oil pro-ducer, America depends more today on imports than it did 30years ago. While industrial oil consumption has fallen, all thosecars, trucks, and SUVs—many driving around in congestedsuburbs—have more than picked up the slack in energydemand. Cheap gasoline has supported the horizontal spread ofsuburbs into exurbs around urban cores and jump-started theunrestrained growth of Sunbelt agglomerations since the igno-minious gas lines of the late 1970s. Today, an extended periodof higher energy prices could slow fringe suburban growthand dampen demand for big houses with their outsized heating/cooling bills. On top of projected rising mortgage expenses,increased gasoline and home-heating costs might tip the afford-ability balance for many people away from home owning toapartment renting at infill locations closer to work. Going for-ward, the distance between where we live and work will matter


Going forward, the distance between where we live and work will matter more.

0 1 2 3 4 5

Economic/Financial IssuesJob growth rates

Interest rate changesIncome and wage growth

InflationState and local budget problems

U.S. federal budget deficitsAsian economic growth

Offshoring and outsourcingU.S. trade deficits

European economic growth

Social/Political IssuesThreat of terroism

ImmigrationIraq issues

Economic inequality

Real Estate/Development IssuesConstruction costs

Vacancy ratesLand availability issues

Growth controlsLack of adequate infrastructure

Future home price inflationNIMBYism

Urban redevelopmentFuture home price stagnation/deflation

Availability of affordable housingTransportation funding

Place makingEnvironmental issues

Green buildings

Exhibit 1-10Importance of Various Trends/Issues/Problems for Real Estate Investmentand Development in 2006


1 = no importance, 2 = little importance, 3 = moderate importance,4 = considerable importance, 5 = great importance.

more, and attractive mixed-use places (in both cities and sub-urbs) that offer more convenient urban lifestyles will benefit.Greenfield developers beware.

“Numbing” Deficits. Balance of trade and federal budgetdeficits have “been talked to death.” Cassandras warn that foreign-ers (led by the Chinese) may rebalance investments out of theUnited States (now the world’s biggest debtor nation), furtheraffecting the buying power of the dollar and forcing majorupward adjustments in interest rates. Low interest rates, mean-while, have supported U.S. consumer spending on Asian imports,which allows Asian expansion and investment in U.S. Treasurybills, creating even greater imbalances. The decoupling of theyuan from the dollar bears watching, but many interviewees arguehopefully that deficit problems are a “future concern,” “not a real-time issue.” “We’ll have to deal with them, but not yet.” Keepyour fingers crossed as Iraq and Katrina pile on more red ink.

Hurricane Havoc. The horrific Gulf Coast hurricanes are justthe sort of “bolt out of the blue” that many interviewees fear couldupset the economy temporarily and stall momentum in real estatemarket recoveries. Expect the storms’ impacts to be decidedlymixed. The nation’s reduced refining capacity threatens to sustainrecord or near-record gasoline and home-heating prices just as gov-ernment economic stimuli—low interest rates and tax cuts—havelost some of their effect. This news offers little comfort to retailers,homebuilders, or even hotel owners—people may curtail car trips,air travel, and overall spending. Building materials can onlybecome more expensive as the massive cleanup and reconstructiongear up, opportunely restraining development passions in slowlyfirming commercial markets. In most of the country, homebuildersmay be forced to slow down, too. Federal aid and insurance pay-outs eventually will generate an economic jolt, especially in theaffected area, where building activity will skyrocket. Property andcasualty insurers, meanwhile, will increase rates on all propertyowners to recoup some of their massive losses. New Orleans’s crip-pled port (number one for domestic cargo) and convention indus-try (number five nationally) will benefit warehouse owners andhoteliers in other markets—shippers and meeting planners willneed to look elsewhere, at least temporarily. Apartments in cities inthe South and Southwest will see a slight bump in demand fromdisplaced storm victims. Nearby Houston could be the big winner.For affected residents, owners, and investors, Katrina and Rita havebeen devastating. Speculators and vulture investors will circle thescene looking for bargains. A shrunken New Orleans may need torely even more on tourism and entertainment to shore up a flag-

ging local economy. Gulf Coast shorelines will rebound—everyonetreasures a water view until the next storm hits, and the Mississippigambling industry will gain the necessary government backstopsand tax concessions to rebuild.

Terrorism. London, Iraq, Madrid, 9/11, Israel—attacks con-tinue, life goes on. Convinced that another strike in the UnitedStates is inevitable (“You can’t be complacent; it’s not a matterof if, but of when”), interviewees increasingly reconcile that anydislocation should be manageable and markets can rebound.“It’s become a background issue that you really can’t plan for.”The way real estate pricing roared back after September 11,who can argue. . . .


Real Estate Climate RemainsFavorable“Something is in the water. For all the advice about selling,more buyers appear.” “It’s a totally sellers’ market.” Says a frus-trated buyer: “I can live with high and rising prices, low caprates, and shortened due diligence, but I have a tough time withthe utter arrogance of sellers who can and do retrade withimpunity. They can get away with anything, because there isalways someone else there to make their deal.” The tremendousbacklog in capital (see Chapter 2) suggests sales momentum cancontinue well into 2006, at least sustaining exceptional pricinglevels for a while longer. “Much of what we sold 24 months ago,we are reselling today,” says a broker. “It makes putting the salesbook together easier—nothing much changes, not even the leas-ing.” Business profitability prospects remain strong, and a favor-able climate extends not only to brokers and investors, but tolenders and developers as well (see Exhibits 1-11 and 1-12).

“Pricing to Perfection.” Recent stories about flipping prop-erties have become legion. “I just sold a B mall at a cap rate 300basis points below the purchase with the same competitive set,same anchor credit issues and weaknesses, literally no improve-ment over my holding period.” “I sold a property bought twoyears ago with a flat NOI since, at a huge gain, all thanks to thefinance markets.” Brokers scratch their heads over successful salesstrategies, which leave space vacant rather than trying to lease itup. “It’s amazing. The buyer sees opportunity in the vacancy, so


don’t mess with his imagination.” Meanwhile, cash-rich sellershave done so enormously well that instead of folding, theyacquire something else. It’s the relative value argument—I can’tdo better in alternative investments, so I’ll stick to real estate.

Commodity Mentality. Concerns grow about the franticpace of trading. “Many investors have no strategic plan beyondcap rates going down and have been spoiled by immense liq-uidity where everything trades.” Properties “are not priced forrisk when buyers acquire 50 percent leased buildings at pricesfor 100 percent leased buildings.” Not only are investors count-ing on “aggressive cap rate assumptions,” but they are alsoanticipating “significant rent recoveries” and using “substantialleverage.” At best, many investors “risk selling for no more thanthey bought.” “People are fooling themselves a bit.” “They maynot have a chair when the music stops.”

Core Conundrum Redux. Conflicted owners of well-leased,income-generating core portfolios mostly steer clear of the dispo-sition market unless they cull underperforming assets. “Arguably,it’s the optimal time for them to harvest, but people are hangingonto most safe core assets. It’s like not wanting to sell your house,because you’ll have to buy another at an equally high price.”Faced with billions of dollars in queued investor commitments,

large core investment funds struggle to find acquisitions thatmake sense—“there’s considerable risk from pricing.” Theyexpand the “core” definition using more leverage on deals andtread into shallower secondary markets as well as into niche seg-ments. Proponents argue that core (locked-in credit tenants withgood income streams) remains a better bet than value-add oropportunistic strategies that have rehab, development, and/orleasing risk. But core funds have enjoyed the benefit of signifi-cant appreciation from cap rate compression and are more vul-nerable to some “give back” if and when cap rates rise. Severalmajor institutions counsel a temporary “move away from core,”“expanding the playing field to more opportunistic investments.”Over the longer term, investors prefer the lower-risk core profileand solid, predictable yields.

Few Value-Add Bargains. More investors gravitate to valueadd, contending that these properties will be more resistant tocap rate reversion since their strategy is to upgrade lagging per-formance. “You can achieve slightly better pricing, fewer dollarsare chasing deals with a little hair, and play into improving mar-kets,” says a pension consultant. “Right now, the risk is easier tounderstand and underwrite” with better return potential. “Evenif you don’t hit your target return, chances are you won’t do anyworse than core,” says a value-add manager. But value-addinvestors have trouble finding reasonably priced deals, too, andmust “go up the risk curve for lesser returns.” “It’s hard to get


The unprecedented hurricane destruction creates a massive need for rebuilding and can only increase demand and cost for materials and supplies.

Exhibit 1-11 Real Estate Firm Profitability ForecastProspects for Profitability in 2006 by Percentage of Respondents

Prospects for Profitability in 2005 by Percentage of Respondents


Poor 0.71%Fair 2.13%

Modestly Poor 0.35%

Modestly Good 9.57% Good 26.60% Very Good 33.33% Excellent 20.92% Outstanding 6.03%

Very Poor 0.36%Fair 7.83%

Poor 0.71%

Modestly Good 11.03% Good 21.71% Very Good 25.98% Excellent 23.13% Outstanding 8.90%

dollars out even if you look farther afield” into the niches or atdog properties in tertiary markets. Value-add investors have beengorging on selling B apartments to condominium convertersand entitled land to homebuilders. Those gambits may be losingsome momentum. Leverage, a major ingredient for enhancingvalue-add returns, likely will get more expensive, too.

Not in the U.S.A. For now, opportunity investors shift theirsights overseas, particularly to Asia. Loaded with dollars, theycan find only slim pickings back home: residential land, timber,marinas, golf courses, hospitality, and condominium develop-ment or conversions. “Everybody and his brother have set upprivate equity real estate funds—it’s unbelievable the amount ofmoney.” “Many players don’t even know what they are lookingfor.” If development resumes, opportunity and hedge funds willbe prime funding sources.

Development Gears Up. In 2006, development should bethe lead signpost for real estate markets. If new construction stayslimited and under control, recovering markets in office andindustrial will move toward equilibrium with restored pricingpower for owners and investors. But if developers start buildinginto the capital torrent, then recovery would be stunted whenprojects are completed in 2007 and 2008. Relatively sluggishtenant demand and historically high vacancies in many marketsargue against most development. “When you start building foran investor market, problems follow and that’s been happeningin condominiums and multifamily.” “Restraints are coming offwith so much crazy capital out there; development guys are gear-ing up. The compression of cap rates allows builders to proceedat lower underwriting, and acquisitions are well above replace-ment cost, even [after] calculating in higher material costs.”Interviewees have been touting improved market transparencyfrom stock and bond research, rating agency scrutiny, and thewealth of timely research information gleaned off the Internet.If evidence of new building wells up in Wall Street research andREIT/CMBS reporting, will it stanch investor and developerconstruction appetites? The test may come in 2006 and 2007.

Cost Concerns. Material and labor costs could be a significantleavening influence on new building in all sectors includinghousing. Interviewees continue to suggest that concrete and otherbuilding materials have shot up 10 to 30 percent, well abovereported inflation figures. The same building boom has createdlabor shortages among skilled construction workers in some mar-kets, stalling projects and boosting wage rates. The unprece-

dented hurricane destruction creates a massive need for rebuild-ing and can only increase demand and cost for materials andsupplies. Nationally, land prices also skyrocket, “driven by loosemoney.” Properties coming on line today will cost less than next-generation projects in two to three years. Until now, developerscould pass on increased expenses through higher rents and salesprices, but the escalations begin to deter buyers. A sales slow-down because of pricing resistance on top of rising mortgagerates will cut homebuilders’ margins. Commercial builders wouldalso have more trouble justifying projects on the drawing board,if returns pencil out below expectations of lenders and partners.

Growth Controls. Antigrowth influences continue to plaguesuburban developers, who increasingly face moratoriums andhigher infrastructure fees. More localities reject developmentsattractive to families with children, which would raise schooltaxes. The burden for paying for new roads and sewers increas-ingly shifts to developers, as federal and state grants are curtailedin budget cuts. Better-capitalized developers—large regional andnational builders—have more staying power than many localbuilders to navigate the system and get approvals. But small localplayers won’t be muscled out of their backyards. They still havean edge in local relationships and market knowledge. Growthcontrols, land availability issues, and lack of adequate infrastruc-ture were all top-rated issues—deemed to be of considerableimportance—among survey respondents (see Exhibit 1-10).


can only increase demand and cost for materials and supplies.

0Abysmal

5Fair

10Outstanding

Real Estate Services

Homebuilding/ResidentialLand Development

Financing as a Lender

Commercial/MultifamilyDevelopment

Investment

Exhibit 1-12Real Estate Business ActivitiyProspects in 2006


InvestmentSell NOW! How much higher can prices get? All signs point to higherinterest rates. Cap rates may not rise in lockstep, but occupan-cies and rents may not increase enough to prevent some depre-ciation, except on trophy properties in the top markets. Upsidepotential diminishes, while downside risk increases. Harvestgains now from the “phenomenal” recent cyclical run-up.

Back Off AcquisitionsRemember in 1980 when we thought money market accountscould yield 10 percent forever and in 2000 when the Dow hadprospects for reaching 20,000 by 2005? Think back five years agowhen all those Internet “paper millionaires” were planning toretire by age 29. Accepting reasonable relative value argumentsthat real estate’s risk premium has lowered, too many recent deals“have blown away [risk/return] parameters.” “It’s very hard tomake an investment today that won’t have cap rate reversion.”Under any circumstances, “avoid paying above replacement cost”and steer clear of broker-orchestrated auctions.

Invest in AsiaPacific Rim countries represent “the only high rate of returnpossibility.” China and India show substantial growth potential.The region gains greater economic clout and attracts investorflows despite volatility, questionable transparency, and currencyrisk. “China is the future” and India needs new space to houseits growing economy and the outsourced jobs from the UnitedStates and elsewhere. A growing middle class in both countriesspurs demand for better housing and more shopping centers.

Money Market Funds, T-billsTake sales proceeds and wait for any market dislocation. Ifsome condominium markets crater, pounce on opportunities.REITs will look better after a correction. But 2006 could be agood time to “pass on real estate” and take a breather.

Hold CoreHigh-occupancy core properties in prime locations (24-hourcities/coastal markets) may cycle into a period of fixed-income–like returns without much appreciation, but over anextended holding period their risk-adjusted performance profileswill wear well. Rents should trend up as vacancy rates declinefurther in most markets. Locking in extra fixed-rate financingcould add positive leverage before interest rates rise any more.

DevelopmentDevelop Infill Housing and Mixed UseThe demographic trends continue—empty nesters move backinto cities for more convenient lifestyles while their childrendelay marriage and build careers in urban nodes where nightlifeand social action are attractors. High gas prices and suburbancongestion also stimulate more interest in urban alternatives—namely, 24-hour downtowns and mixed-use districts. Transit-oriented development near subway or light-rail lines almost can’tmiss. “People congregate there.” Supermarket and restaurantcomponents in residential high rises “create stronger demand.”In cities, the value-add play converts obsolete office buildingsinto residential space, and aged warehouse space into lofts. Insubcities, developers add residential components to shoppingand lifestyle centers. New mixed-use town centers in the suburbsare also one of the hottest development trends going today, butthey are not easy to pull off and won’t work just anywhere.

Develop Age-Restricted CommunitiesThe vanguard of the baby boomer cohort is too young, healthy,and active for assisted living facilities, let alone nursing homes.But late 50- and early 60-somethings, who like the suburbs,relish easier lifestyles in age-restricted communities for seniors,whether consisting of townhouses, apartments, or villas. Roomylayouts are comfortable, but without the hassle of keeping up asingle-family home. Interest in seniors’ housing will only buildover the next two decades, but developers need to avoid gettingahead of the demand curve.

Develop Resort/Second HomesCondominium development is out of hand in some markets,but demand for unique waterfront properties and resort com-munities will be sustained in coming years by baby boomers,


High gas prices and suburban congestion also stimulate more interest in urban alternatives.

Best Bets 2006

preparing for retirement and enjoying the fruits of their peakearning years with tuition and child-rearing costs behind them.Anything has possibilities on beaches and lakes or with attrac-tive mountain views within a two- to three-hour drive of majormetropolitan areas. Despite the threat of hurricanes, prices sky-rocket along the Florida palm coasts to Mississippi. Katrina-ravaged beachfront will bounce back. Forget about Cape Codand Nantucket; even houses on Lake Champlain in Burlington,Vermont, sell for north of $1 million! Great Lakes retreats arecoveted, too. Colorado and Mountain West ranches and skichalets get gobbled up. “Noncommodity places and homesappeal the most.” Hotel resorts with adjacent condominiums orhomes also provide attractive services and amenities. Extra bed-rooms are always a plus—in case the grandkids want to visit.Land banking in second-home country makes sense—demandfor “special getaway places” will only grow, and these propertiesshould show strong appreciation as longer-term investments.

Take Caution about Other DevelopmentThe capital markets may signal opportunity for new develop-ment, but soft occupancy rates and only slowly improvingoperating margins in many cities and suburbs reinforce theview “that commercial real estate doesn’t need a new anything.”Building upscale hotels may make sense in some undersuppliedmajor cities and resort areas, but a spate of new office projectscould easily sidetrack recoveries, except in the few already tightmarkets with growth prospects. Apartment developers need tobe wary of recently converted condominium projects turningback into rentals. Growing obsolescence in warehouse marketspresents opportunities for new space, but selectively. Again,vacancies are still high in many places. Demand for niche realestate—self-storage, medical offices, student housing—couldeasily be swamped if too much product gets built too quickly.Homebuilders need to read the tea leaves and back off.

Property SectorsHold Full-Service HotelsBusiness center hotels have “roared back” and resorts gainmomentum. Executive road warriors fill rooms and a weak dol-lar fuels foreign tourism. A lack of inventory helps drive pricingpower ahead of any new supply, which will be several years off.

Buyers confront rich pricing—RevPAR growth has not escapedanyone’s notice. Sell limited-service or “dog-eared” productinto the acquisition frenzy. Timing couldn’t be much better.Investors, however, need to keep an eye on the impact thatenergy prices have on travel budgets.

Sell or Hold ApartmentsApartments are a mixed bag. Demographic trends support con-sistent, future demand growth and rising mortgage rates por-tend increased numbers of renters. But cap rates have pushedprices well above replacement cost and look unsustainable.Rental markets with heavy condominium development andconversions may backslide if speculative buying cools. Thehigh-income apartment category seems particularly vulnerable.Selling sentiment outweighs the buy side, but holders shoulddo well over time.

Hold WarehousesA classic core investment, industrial real estate consistentlydelivers bond-plus returns. Investors almost can’t miss holdingonto facilities in major distribution hubs and ports. It’s a goodtime to weed out or redevelop obsolescent space—propertieswith low ceilings, short turning radii, etc.

Sell Commodity OfficeDespite recovering markets, cap rate compression significantlydiminishes or even eliminates appreciation potential on manyoffice acquisitions. Rent growth will have trouble keeping upwith underwriting assumptions. Buyers seem willing to pay pre-miums for almost anything with walls and windows.

Sell RetailAfter fabulous appreciation gains, retail takes a breather.Voracious consumer spending—fed by tax cuts, low interestrates, and mortgage refinancings—may keep up if wagesincrease enough, but don’t count on it. Energy costs and risingmortgage rates could zip pocketbooks. “Retail has all the risk.”


alternatives.

Outlook Through 2010 During the next real estate cycle, Emerging Trends’ respondentspredict that property markets will become more global andmore public, and U.S. real estate markets will sustain interestfrom capital sources of all stripes attracted by steady propertycash flows. Meanwhile, sprawl issues, congestion, and thepotential for higher energy prices will accentuate the desirabil-ity of suburban town center developments and more conven-ient urban lifestyles. Following is a digest of interviewees’longer-term forecasts:

Relative Value Endures. Capital flows into U.S. real estatewill remain ample, and market liquidity will decrease volatilityas well as overall returns—cap rates trend below historic norms.“Real estate will be viewed as an inflation-indexed bond and amust for mixed-asset portfolios.” Aging baby boomers, requir-ing greater safety and predictability from retirement savings,will seek more income-oriented investments. Pension funds willcontinue to increase allocations to real estate as payouts swell toexpanding numbers of retiring beneficiaries. REIT- and CMBS-related investments—including more sophisticated syntheticbond products and derivatives—gain favor. Subtext: While pen-sion allocations increase, defined-benefit plans look more likedinosaurs. Corporate entities replace defined-benefit formatswith defined contribution/401K plans more suited to mutualfund/public market investments than illiquid private real estate.Public funds eventually will follow suit. So far, investmentmanagers have struggled to structure private equity vehicleswith liquidity features to meet the growing market demand.

Everything Globalizes. “Investment horizons expand dra-matically” as foreign securities markets blossom. REITs onlynow sprout in Asian and European countries. “These marketswill mature very quickly” when more companies go public.Cross-border transactions by investors and operators willbecome routine. Following the lead of lodging companies,retail, industrial, and office developer-managers will morph intointernational operations. They link strategies to the interests ofgrowing numbers of tenant clients who operate worldwide.Subtext: “The rise of China could rewrite economic rules.”More investment capital will flow into China and India fromaround the world and both countries will be a greater sourceof investment capital for U.S. real estate markets.

CMBS Dominate. CMBS markets also expand well beyondthe United States, and domestic CMBS market share expands incommercial and multifamily lending. Offerings will increase insize, “accommodating megadeals while improving liquidity andtransparency.” In general, mortgage debt becomes more commodi-tized, securitized, and sophisticated with even more segmented riskto match investor appetites. Continuing industry integration “willmake debt more of a driver” in the capital markets.

REITs Consolidate and Grow. REITs follow the global-ization trend, becoming multinational with cross-border list-ings. The industry consolidates further into bigger, more insti-tutional companies. Governance and regulatory hassles frustratesmaller companies, which go private or merge into bigger com-petitors. Overall, the REIT sector expands its market share ofreal estate ownership. Pension funds may allocate more to theasset class, but increasing numbers of defined contributionplans invest through REIT mutual funds.


More investment capital will flow into China and India from around the world and both countries will be a greater source of investment capital for U.S. real estate markets.

Focus on Infill. Some areas reach the limits of their patienceover sprawl and traffic—communities in southern California“approach a crisis stage.” Places without mass transit struggle. Ifgas prices stay high, people in outer suburbs may start joining“the move back in.” Inner cities will clear or redevelop moreold industrial sites and obsolete office buildings for residentialneighborhoods with retail and office components. Leading-edgeexamples have been Denver’s LoDo and Atlanta’s AtlanticStation. Transit-oriented development gains momentum asmore suburban agglomerations expand light-rail initiatives toreduce dependence on car travel. “LoDo is the future, suburbanoffice parks are the past.” Boomers and echo boomers will con-tinue to dictate residential trends toward more infill.

More Suburban Mixed Use. In the outer suburbs, “Urbantown centers will be the rage.” “Big-lot housing becomes morea thing of the past.” Again, escaping traffic and finding conven-ience push the trend. Pressure builds from people who want tolive in places where they can shop, work, and play. These devel-opments must creatively incorporate retail, other commercialspace, parks, and recreation areas into projects with apartmentsand single-family housing. Closed military bases and ghost

malls will continue to offer large tracts for redevelopment.Flagging office parks could also present possibilities. Sprawlwon’t die, but it becomes less acceptable.

Greater Energy Efficiency. Every time gas and heatingprices spike, the ignored topic of energy conservation and effi-ciency gets resurrected. Energy experts endlessly debate levels ofoil and gas reserves. Environmentalists cry wolf, but then pricesalways seem to dissipate. Will they fall again this time? Anextended period of sticker shock at the pump and jaw-droppingutility bills would change behaviors and demand drivers forboth home and commercial owners, reinforcing move-back-inand town center trends. Developers will need to stress more“green” development and rehab as tenants resist higher electric-ity and heating tabs.



both countries will be a greater source of investment capital for U.S. real estate markets.

CapitalRealReal E

Capital

“Capital markets have

embraced real estate in a

bear hug.”

Everybody into the pool, “capital galore” has “inundated”the entire real estate market, “all segments and niches.”Huge amounts of money (an estimated $50 billion–plus

from pension funds alone) “stack up on the sidelines.”“Investment markets can’t handle all the capital in play.” “Solidreturns become a self-fulfilling prophecy as long as capitalgushes.” Many interviewees contend that the “unabated capitalfrenzy” ensures that cap rates will stay low for the foreseeablefuture, certainly through most of 2006, barring an unforeseenexogenous shock. “The flows will continue because real estate isa good investment and now operating performance is beginningto improve.” “Irrational exuberance stays alive for another year,”as long as the “interest rate environment remains benign.”

Emerging Trends surveys forecast a minor falloff in capitalavailability during 2006. “Capital will still be over flood stage,maybe five feet over instead of ten, but a flood is still a flood.”More than 86 percent of Emerging Trends respondents predictthe equity capital markets will be moderately or substantiallyoversupplied in 2006, while about 81 percent forecast the debtmarkets will be oversupplied (see Exhibit 2-1). On the equityside, survey respondents see private investors, opportunityfunds, and pension funds leading the charge, while CMBSissuers, gaining market share, and money center banks domi-nate the debt markets. (See Exhibit 2-2.)


c h a p t e r 2

Exhibit 2-1 Real Estate Capital Market BalanceForecast for 2006


1.42% Substantially Undersupplied4.63% Moderately Undersupplied

7.47% In Balance

54.80% Substantially Oversupplied

31.32% Moderately Oversupplied

0.35% Substantially Undersupplied4.96% Moderately Undersupplied

13.48% In Balance

40.43% Substantially Oversupplied

40.43% Moderately Oversupplied

Equity

Debt

EstateFlows

This extremely deep capital market for real estate also “cre-ates a governor or floor,” protecting investors from downsiderisk should property sectors weaken or some capital leave themarket. “A huge number of opportunity funds are waiting forprices to fall, and as a result prices won’t drop as much whenand if they do.” “It amounts to a buy-side backstop.” A hugeamount of real estate remains on corporate balance sheets, andsome companies sell into this favorable market.

Is the End Near forUnrestrained Capital Flows?For all the confidence about real estate’s relative value and new-found transparency, many interviewees nervously sense “the endis near or very near” for unrestrained investment, which has bidup pricing to giddy levels, given current property revenues.“Everybody has been overreaching.” “It’s gotta stop, it’s nuts.”After more than ten years “with the wind at their backs,”investors “assume very low losses.” “Yield has become a moreimportant metric than risk-adjusted return,” especially in ana-lyzing higher-risk CMBS tranches. “Everybody looks throughthe rear-view mirror instead of through the windshield.”

Judgments about the amount of “hot money” inflating themarket vary. A reasonable estimate suggests that capital flowscomprise 50 percent “cool capital” from long-term, experiencedplayers; 25 percent “warm” money from new investors lookingfor diversification and real estate’s touted benefits; and 25 per-cent hot, highly leveraged hedge fund and tenant-in-common(TIC) investors. “It’s crazy, all the new people coming into realestate,” says a Southwest developer. “I’m getting my shoesshined next to two oil guys who are talking about a condo-minium conversion project. Who are these guys? It leads toexcess.” “Herd capital” could pull back on a dime if adversitystrikes or better opportunities in alternative asset classes comealong. “Unregulated lenders—mezzanine and hedge funds—will disappear if there is an interest rate spike.”

Lenders and investors have looked to limit their risk as theyloosen investment parameters and pour money into propertyinvestments. Liberal bank and conduit underwriting—high loanto values, low debt service coverage, little or no reserves—permitsbuyers to “have less skin in the game.” Increasingly, owners takethe opportunity to “cash out” substantial property stakes, usingrefinancing stratagems, including doses of floating-rate debt.“They are basically selling most of their equity. It will be easy towalk away if trouble hits.” Lenders participate in or issue CMBSofferings to take loans off their books and spread risk across bondmarkets. Upwards of 75 percent of loan originations becomesecuritized. “Securitizing makes it easier to take risk less seriouslywhen you make loans,” says a leading banker. For CMBS bondbuyers, complex tranche structures layer and diffuse risk further.Securitization creates “some moral hazard”—investors have “lessat stake and shorter-term investment horizons.”


“A huge number of opportunity funds are waiting for prices to fall, and as a result prices won’t drop as much when and if they do.”

0Abysmal

5Fair

10Outstanding

2006 2005

Exhibit 2-2 Availability of Capital for Real Estatein 2005 and 2006


All Sources

Private Investors

Opportunity Funds

Pension Funds

Foreign Investors

REITs

All Sources

CMBS Sector

Major National Banks

Local/Regional Banks

Insurance Companies

Savings Institutions

Equity Capital

Debt Capital

Everyone draws considerable comfort from very low delin-quency and default rates, which reinforce the notion that lowinterest rates helped owners weather patches of soft tenantdemand, and ensuing market upturns now create solid revenuemargins to more than cover debt service. (See Exhibit 2-3.) Butthese extremely rosy numbers may be a little deceiving. “CMBSdelinquency and default stats have been clouded by huge recentissuance,” says a leading researcher. The numerator of under-performing loans looks small compared with the expandingdenominator and the overall size of the market. Take away thenew issuance and problem loans would look bigger, but stillvery much under control. Also, the voracious transaction mar-kets gobble up just about anything for sale. Owners can disposeof weak properties and avoid distressed pricing.

A majority of interviewees expects underwriting standardsto tighten (37 percent) or stay the same (46 percent) during2006. (See Exhibit 2-4.) Only 17 percent suggest that standardswill become less stringent. Generally, interviewees applaudlender discipline on holding the line on speculative develop-ment projects and keeping the market supply side in check.Bankers demand significant owner equity (20 percent or more)

and meaningful preleasing before entertaining constructionloans, at least for office, retail, and industrial projects. Lendersget lower marks for bankrolling property acquisitions and refi-nancing properties. “Securitized lenders have relaxed standardsmore than conventional lenders.”

In recent years, enraptured borrowers have delighted in abacchanalia of easy money, but the good times may be fleeting.Floating-rate debt looks increasingly less attractive in the face ofrising short-term interest rates. If owners have resisted, it’s stillnot too late to lock in fixed-rate mortgages. When it comestime to refinance in five years in a higher interest rate and caprate environment, borrowers may be tested unless rents showsignificant growth.

Private Investors andSyndicators Over the past five years, many individual investor/syndicatorshave proved savvy dealmakers, buying at market prices and sell-ing out quickly for excellent gains when prices skyrocketed. Inhindsight, “it’s not been stupid money.” After initially lambast-ing syndicator groups for sucking up “all the deals” at whatthen seemed exorbitant amounts, more conservative investors,especially pension funds, now wish they had been so proactive.“Some syndicators look pretty smart today.”


result prices won’t drop as much when and if they do.”

0

1

2

3

4

5

6

7

8

Exhibit 2-3 Life Insurance Company Delinquencyand In-Foreclosure Rates

Delinquency Rates

In-Foreclosure Rates

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Source: American Council of Life Insurers.

Exhibit 2-4 Underwriting Standards Forecast

37.28% More Stringent

Predicted Change in Stringency of Underwriting Standards forCommercial/Multifamily Mortgages in 2006

45.64% The Same 16.72% Less Stringent


Perc

ent


Capital Sources and FlowsExhibit 2-5 Real Estate Capital Flows

0

300

600

900

1,200

1,500

Public Untraded Funds

Mortgage REITs

Pension Funds

Government Credit Agencies

REIT Unsecured Debt

Life Insurance Companies

Commercial Mortgage Securities

Banks, S&Ls, Mutual Savings Banks

‘05‘04‘03‘02‘01‘00‘99‘98‘97‘96

0

100

200

300

400

500

Private Financial Institutions (REO)

Life Insurance Companies

Public Untraded Funds

Foreign Investors

Pension Funds

REITs (equity and hybrid)

Private Investors (larger properties)

‘05‘04‘03‘02‘01‘00‘99‘98‘97‘96

($ B

illio

ns)

Debt

($ B

illio

ns)

Equity

Sources: Roulac Global Places, from various sources including American Council of Life Insurers, CMSA/Trepp Database, Commercial Mortgage Alert,Federal Reserve, FannieMae.com, FDIC, FreddieMac.com, IREI, NAREIT, PricewaterhouseCoopers, and Real Capital Analytics.

Note: Excludes corporate, nonprofit, and government equity real estate holdings, as well as single-family and owner-occupied residences.


Exhibit 2-6 Real Estate Capital Sources

Sources: Roulac Global Places, from various sources, including American Council of Life Insurers, CMSA/Trepp Database, Commercial Mortgage Alert, Federal Reserve, FannieMae.com,FDIC, FreddieMac.com, IREI, NAREIT, PricewaterhouseCoopers, and Real Capital Analytics.

Note: As of second-quarter 2005. Excludes corporate, nonprofit, and government equity real estate holdings, as well as single-family and owner-occupied residences. Data in thisgraphic are from a different source than in previous Emerging Trends reports, and thus are not comparable with data in previous reports.

Public Equity$289.4 Billion

Private Equity$661 Billion

Public Debt$640.6 Billion

Private Debt $1,888.5 Billion

Public Untraded Funds$0.2 Billion

Mortgage REITs $23.8 Billion

Government Credit Agencies $71.5 Billion

Commercial Mortgage Securities $545.1 Billion

Pension Funds $36.1 Billion

REIT Unsecured Debt$152.1 Billion

Life Insurance Companies $254.5 Billion

Banks, S&Ls, Mutual Savings Banks $1,445.8 Billion

Public Debt

Private Debt









Public Debt

Private DebtPublic Untraded Funds$0.2 Billion








Public Debt

Private Debt


REITs (equity and hybrid) $259.4 Billion

Private Financial Institutions $4.1 Billion


Foreign Investors$52.5 Billion


Private Investors (larger properties)$430.5 Billion

Public Equity

Private Equity








Public Equity

Private EquityPublic Untraded Funds$29.9 Billion







Public Equity

Private Equity

Public Equity$289.4 Billion

Private Equity$661 Billion

Public Debt$640.6 Billion

Private Debt $1,888.5 Billion

U.S. Real Estate Capital: $3,479.5 Billion

Equity Capital: $950.4 Billion

Debt Capital: $2,529.1 Billion

Private capital takes all shapes and sizes. “The dollars are stillout there. You really don’t know who they all are.” Syndicatorscontinue to market pooled funds with large front-end loads tomoms and pops through Wall Street brokers and financial advisers.Tax-advantaged 1031 tenant-in-common (TIC) joint ventures—often composed of wealthy professionals, have jumped on small-to medium-sized deals offered by local developers and operators.Small groups of high-net-worth individuals band together tobuy bigger deals through advisers and developers. Otherinvestors access the market through hedge funds.

Interviewees have shifted concerns about overreaching fromthe real estate fund syndicators to 1031 clubs and hedge funds.Tenants-in-common are “incentivized to pay more” by tax shel-ter schemes, and have actively bid up prices on “marginaldeals,” using large amounts of leverage. “It’s the old syndicationgame by another name. Other investors cannot compete.”“They don’t exercise prudent due diligence, buying ‘as is’ with-out proper reviews on environmental or engineering.” Otherinterviewees are slightly more charitable: “These freewheelersmay not be dumb money, but they take on additional riskwithout a reasonable level of reward.” “Most of the sponsors arereliable.” These investors need to wonder whether their aggres-sive buying and financing strategies will work as well so late inthe pricing cycle.

Stymied by tepid securities and alternative investment mar-kets, hedge funds have turned to real estate to deliver promisedhigh-octane returns. Portfolio managers typically are betterschooled in deal structuring and Wall Street finance strategiesthan the finer points of bricks and mortar. “Not permanentplayers,” “they fool around in a product they really do notunderstand,” “churning deals, pushing up pricing, investing indevelopment.” “They could be a time bomb,” or just suffer lessthan stellar returns.

Not all segments of the private investor market are buying,however. National private players have been far more active intheir acquisitions than local ones. (See Exhibit 2-7.)

Pension FundsFor all the considerable talk about raising allocations, pensionfunds have been active sellers of real estate, weeding portfoliosand taking advantage of capital demand. While values have

escalated and REIT capitalization almost doubled, the value ofpension holdings has leveled since 2000 with no appreciableincrease over the past year. Unquestionably, plan sponsors havehiked commitments, preparing to funnel big money into prop-erty funds and individual deals. Adviser open-end funds havebrimming queues of institutional money waiting to invest. Theproblem remains finding economic deals to fit portfolio strate-gies, especially for core investors.

Always criticized as “late to the party,” most plan sponsorsview greater risk in underweighted real estate positions thanbuying overpriced assets. They want reliable income from prop-erty investments to pay out liabilities to increasing numbers ofretirees/beneficiaries. “For pension funds, real estate is still asmall part of their overall investment allocation,” explains a con-sultant. “Chief investment officers are more concerned aboutgetting diversification benefits than the repricing of recentlybought assets.” In order to allocate dollars more quickly, plansponsors would prefer to pay all cash or use less leverage, butthey realize they cannot compete on price without employingdebt. “There’s a lot of frustration.” “If they stay in the tradi-tional four core categories [office, apartments, industrial, retail],they will never be fully invested.” Instead, plan sponsors allocatemore to value-add funds and buy into niche property sectors. Ifand when more fickle capital leaves the market, institutionalinvestors are poised to fill much of the void, buoying expecta-tions for continued market liquidity and stabilized values.“There is so much money teed up” to keep the revelry going.


For all the considerable talk about raising allocations, pension funds have been active sellers of real estate, weeding portfolios and taking advantage of capital demand.

-6

-4

-2

0

2

4

6

8RetailOfficeIndustrialApartment

User

/Oth

er

REIT

/Pub

licCo

.

Priv

ate–

Natio

nal

Priv

ate–

Loca

l

Inst

itutio

nal

Fore

ign

Exhibit 2-7 Net Capital Flows by Source andProperty Sector

Sources: Real Capital Analytics, PricewaterhouseCoopers.

Note: Net capital flows third-quarter 2004 through second-quarter 2005 inclusive.

($Bi

llions

)

REITsAfter winnowing and selling holdings in recent years, REITs havestepped up acquisitions, extended operations overseas, increasedjoint ventures with institutions, and continued mergers and con-solidations. Soaring stock prices beg for correction. “REITs aremore susceptible to hot dollars leaving than the private marketsand could lead pricing down.” Spiking total returns, averaging20 percent annually, have made these property companies WallStreet darlings. “REIT prices will need to adjust if interest ratesincrease or the stock market rallies. The group is overvalued onan NAV basis.” Much-prized dividend growth, REITs’ enduringraison d’être, lags the run-up in their stock prices. Not surpris-ingly, companies begin to tout total returns and downplay thedisconnect in “deteriorating” yields. But “prices need to fall toimprove dividends.” “How much more appreciation can theyhave?” In 1997–1998, when REITs were hyped as growth stocksafter handsome gains, prices plummeted.

Hot stock capitalizations revive REIT acquisition appetites—purchases can be accretive and the companies have been promi-nent net buyers. Joint ventures with institutional partnersremain a popular way to raise lower-cost capital, and increaseinternal rates of return. Some REITs raise money through pri-vate equity funds in a further convergence of public and privatecapital. Sarbanes-Oxley “headaches” and a host of other regula-tions burden small-cap REITs, which cannot easily absorb com-pliance costs and deal with reporting/accounting hassles. Thesecompanies are ripe for acquisition or may go private. Larger-capcompanies look ever more institutional and less entrepreneurialas founding families give way to professional managers.

The most active buyers have been retail and office REITs.(See Exhibit 2-7.) Swallow-hard pricing at home sends somemall and industrial REITs overseas “to find growth.” They alsocan apply their management expertise to underserved markets.“It’s only the beginning of more cross-border activity and list-ings.” Australian REITs expand activities in the United States,expecting to enhance their Sydney stock prices.

Foreign InvestorsAustralian investors, in fact, lead a charge of aggressive foreigncapital into U.S. markets, leapfrogging German investors aswell as Middle Eastern, Irish, and other European players.Favorable exchange rates energize Aussie pension funds, who,

like other overseas investors, gravitate to the large, diverse, andstable American property markets. German syndicators havebacked off—they can’t stomach low cap rates. Saudis and otheroil state investors quietly continue to invest “huge” amounts intheir “American safe haven.” Some South American money


active sellers of real estate, weeding portfolios and taking advantage of capital demand.

-$4,000

-$2,000

$0

$2,000

$4,000

$6,000

$8,000

Exhibit 2-8 Foreign Net Real Estate Investments,2004 to 2Q 2005

Source: Real Capital Analytics.

($ M

illion

s)

-$1,000

$0

$1,000

$2,000

$3,000

$4,000

$5,000

ApartmentIndustrial

OfficeRetail

Exhibit 2-9 Foreign Net Real Estate InvestmentsBy Property Type, 2004 to 2Q 2005

($ M

illion

s)

Aust

ralia

Germ

any

Euro

–Non

Ge

rman

y

Unite

d Ki

ngdo

m

Cana

da

Mid

dle

East

Sout

h Am

eric

a

Othe

r

Paci

fic R

im

Germ

any

Aust

ralia

Cana

da

Unite

d Ki

ngdo

m

Euro

–Non

Germ

any

Othe

r

Sout

h Am

eric

a

Paci

fic R

im

Mid

dle

East

Source: Real Capital Analytics.

focuses on south Florida. Finally, Asian institutional moneyreawakens (net sellers recently) to opportunities in the UnitedStates. Investors from Korea, Japan, and Malaysia increaseactivity, joining Singapore, which has been a consistent player.China will come soon. “It’s inevitable.” Foreign buyers concen-trate in familiar coastal cities, acquiring mostly office and retail.

Banks and InsurersLenders appear to squeeze profits from volume in a competi-tion to put out money. If banks or insurers don’t make loans,borrowers can solicit a host of other sources to structure financ-ings, including commercial mortgage–backed securities(CMBS) conduits, mezzanine lenders, and even hedge funds.“Banks have no pricing power, spreads are too narrow.” “Debtis given away” and “no one seems to be worried.” “Risk has notbeen priced into most deals and reserves have been cut back.”Even interest-only loans creep into the commercial sector.Calming most concerns, defaults and delinquencies stay“benign” as fundamentals improve. “A condo bust may hurtsome local banks in south Florida, but otherwise bank risk isspread out in securitized pools and syndications.”

Most developers tout “prudent” bank lending practices forconstruction loans in office, retail, and industrial, “but the damhas burst in multifamily and single family.” “For now, bankshave controlled development, but there is a lot of money still tolend.” Banks and insurers keep moving loans off their booksinto securitizations and the vast global capital markets suck upthe real estate bonds so lenders can redeploy the proceeds liber-ally. Insurers continue to increase investments in CMBS at theexpense of more traditional whole-loan lending, which requireslarger reserve requirements from industry regulators.

For the first time, some interviewees question whether banks’institutional memories begin to fade over profligate lendingpractices, which precipitated their early 1990s financial debacleand the S&L industry collapse. “Today’s lending is withoutquestion the most aggressive in the past 15 years.” The FederalReserve sends signals of increasing unease. As long as propertyrevenues grow, borrowers will be well positioned to cover debtservice, even as interest rates increase. Lenders, meanwhile, jetti-son risk into the securities markets. What, me worry?

CMBSCMBS offerings proliferate—2005 issuance could exceed therecord 2004 pace by more than 50 percent. (See Exhibit 2-10.)Although spreads narrow, investors devour CMBS for their pre-mium yields over comparable corporate bonds, treasuries, andother fixed-income alternatives. The bond markets perceive nogreater CMBS risk thanks to low delinquencies and improvingproperty sectors. For conduits and investment banks, thedecade-old “dream has been realized.” CMBS have become a“mainstreamed” core fixed-income investment product. “Evenpension funds have warmed up and become buyers.”

Nothing short of revolutionary, the CMBS impact on U.S.real estate markets has been mostly responsible for providinga strong, consistent source of liquidity to property owners.During the past decade, a rigorous industry infrastructure hasevolved to arrange, analyze, research, distribute, and supportofferings. “The markets have become quick and efficient withgreat transparency and information.” B-piece/unrated buyershave remained disciplined and “fairly stringent,” kicking out


Lenders appear to squeeze profits from volume in a competition to put out money.

$0B

$100B

$200B

$300B

$400B

$500B

$0B

$20B

$40B

$60B

$80B

$100B

Exhibit 2-10 CMBS Market

Sources: Federal Reserve, Commercial Mortgage Alert, PricewaterhouseCoopers.

Note: Issuance and market capitalization data are for both commercial andmultifamily mortgages. *Data for 2005 are for the first two quarters only and not annualized.

■ CMBS MarketCapitalization

CMBS Issuance

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*

Capi

taliz

atio

n

Issu

ance

bad loans from mortgage pools. Rating agencies add consider-able oversight. But some interviewees suggest investors andrating agencies should “push back more” on offerings.“Deterioration in credit quality could be with us for a longtime.” “Securitization has helped spread the risk, but now manylenders have weakened their standards.” Conduit lenders won-der whether discipline can hold together. “The market still hasnot been tested. We’ve had everything going our way since thestart 13 years ago—a long up-cycle, low interest rates, and nowimproving markets.”

CMBS markets expand overseas into Europe and Asia, butcross-border investing “has a ways to go.” Impediments includecurrency and tax laws.

Mezzanine InvestorsFor mezzanine investors, “discipline becomes the name of thegame.” Underwriting standards appear to slip more precipi-tously and some lenders may misprice risk. Oversight is mini-mal and the market is less transparent. “The only place wesee questionable loans is [with] mezz, where lenders are notsubject to rating agencies,” says a leading mortgage banker.“Imprudent” condominium lending has fueled the conversionmarket, and may come back to haunt. Mezz loans—based oninflated valuations, interest-only payouts, low reserves, and noescrows—have made it easy for borrowers to cash out large por-tions of their equity stakes near market pricing peaks. Somemezz lenders could get left holding the bag, which is fine withtraditional lenders higher up on the capital stack.



Marketsto

Marketsto

“An institutional bias

predominatesfor selected cities, but secondary

markets see plenty of action.”

A ny discussion of the nation’s top real estate marketsreverberates like an echo chamber—“Coastal cities,coastal cities; barriers to entry, barriers to entry; D.C.,

New York, southern California, D.C., New York; coastal cities,coastal cities . . . .” “Everyone is using the same data and reach-ing the same conclusions.”

Corporations continue to consolidate operations along globalpathways. They prefer larger cities with transportation and com-munications hubs, facing Asia, Europe, and Latin America. NewYork dominates finance. Washington, D.C., is the world powercapital. The top California markets gain from their Pacific Rimperches and strength in technology, entertainment, and a host ofother sectors. Miami and south Florida benefit from proximityto South and Central America. For investors, the concentrateddemand in a few major markets “has made it hard to generateyields.” “Everything has been picked over.”


In fact, hungry capital knows few limits today and huntsfor deals in lower-growth and even no-growth regions and sub-markets, bidding up prices almost everywhere. Of the 63 met-ropolitan area markets and submarkets in our survey, 57 havefair or better investment prospects. “No overlooked marketsexist.” “An institutional bias predominates for selected cities,but secondary markets see plenty of action.” “I’m investingin Birmingham and Boise.” The only steer-clear places areincreasingly the Rustbelt manufacturing citadels. Nevertheless,investors sniff around for transactions in some of these cities,too—“anything to put money out.” They sideline concernsabout limited exit strategies and shallow tenant pools, takingsolace in recent market gains. “Even the softest markets showsigns of coming back with rising occupancies, improvingabsorption, and slight rent improvements.”

c h a p t e r 3

Watch


Many investors look beyond top cities searching for value.

San Diego

Washington (overall)

Northern Virginia

Washington, D.C.

Maryland Suburbs

Los Angeles (overall)

Orange County

Riverside/San Bernardino

Los Angeles County

New York (overall)

New York City

Newark/Northern New Jersey

Westchester/Fairfield

Long Island

Phoenix

San Francisco (overall)

San Francisco/San Mateo

Oakland/East Bay

Honolulu/Hawaii

San Jose

Sacramento

Seattle

Las Vegas

Orlando

Austin

Boston

Miami (overall)

Fort Lauderdale/West Palm Beach

Miami/Miami Beach

Tampa/St. Petersburg

Virginia Beach/Norfolk

Portland, Oregon

Jacksonville

San Antonio

Baltimore

Salt Lake City

Raleigh

Denver

Minneapolis/St. Paul

Chicago (overall)

Chicago Suburbs

Chicago City

Charlotte

Atlanta (overall)

Atlanta Suburbs

Atlanta City

Houston

Tucson

Philadelphia

Dallas/Fort Worth

Kansas City

Nashville

St. Louis

Cincinnati

Memphis

Providence

Indianapolis

Milwaukee

Pittsburgh

Cleveland

Columbus

New Orleans

Detroit

Exhibit 3-1 Markets to Watch

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

6.977.056.766.866.836.696.906.946.786.897.087.026.756.506.516.496.736.496.886.906.846.776.766.616.516.796.636.276.316.386.536.586.886.095.856.106.055.986.035.955.796.216.276.286.076.235.405.676.615.675.976.355.685.986.235.986.006.144.875.196.126.045.94

6.125.635.546.056.155.175.885.945.845.835.155.145.785.175.335.755.905.036.306.265.825.915.855.255.745.885.675.585.175.535.525.205.435.515.275.395.465.245.795.414.745.355.405.115.335.385.115.045.314.764.855.305.055.335.284.884.815.364.965.155.124.594.39

5.245.064.945.114.774.645.074.804.714.974.604.785.054.884.655.055.305.145.044.675.004.864.444.304.854.534.854.834.924.954.784.544.804.614.004.534.614.244.754.594.474.844.564.234.684.374.194.654.093.724.384.043.393.833.873.563.813.733.654.163.543.093.63

Prospects for Commercial/Multifamily Investment and Development


■ Investment ■ Development■ Supply/Demand Balance

Coastal Cities StillPreferred, butForaging IncreasesEmerging Trends’ market ratings for invest-ment, development, and supply/demandbalance reflect heightened prospects forcommercial/multifamily sectors of mostmetropolitan area markets—they gener-ally improve across the board from the2005 survey. Here are the key highlights:

Southern California Leads. Forthe first time ever, San Diego climbs tothe top of Emerging Trends’ market rank-ings, just ahead of perennial leaderWashington, D.C. Greater Los Angelesfollows closely, with its booming OrangeCounty leading the way. SouthernCalifornia parlays extraordinary climate,geographic barriers (desert, mountains,and ocean), deepwater Pacific ports, andan extremely diversified economy (enter-tainment, defense, biotech, finance, serv-ices). Dynamic demand and constrictedsupply translate into the nation’s bestplace to invest. But interviewees worryabout debilitating traffic congestion andthe region’s car dependence. High costsand rising taxes strain lifestyles, whileincreasing numbers of poor immigrants,mostly from Mexico and other CentralAmerica countries, transform the state’sdemographic profile.

East Coast Stalwarts. D.C. andNew York become ever more strategic as America’s primary global gateways.Corporations and world elites “need to be

there” and investor hoards follow. Thesecore markets exemplify stability and pros-perity—they swim in liquidity. Yieldsplunge, but holdings look very safe.Buildout along the Atlantic Coast throughthe Northeast megalopolis creates desirablebarriers to entry. “You almost can’t gowrong on anything within 100 miles ofthe coast.” Philadelphia and Baltimorecontinue to get lost in the shadows.Boston suffers from recent corporate con-solidations, but retains its attractive 24-hour profile and strong talent pool ofworkers.

Looking Beyond Prime Markets.Many investors look beyond top citiessearching for value. Several smaller andmedium-sized Sunbelt and coastal mar-kets gain in rankings, notably Phoenix,Honolulu, Sacramento, Seattle, LasVegas, Orlando, Austin, and Tampa/St.Petersburg. While hampered by a lack ofdevelopment restraints—geographic andland use controls—these areas remainpreferred places to live and work. Cali-fornia spillover is especially notable.Phoenix’s, Las Vegas’s, and Sacramento’ssolid rankings recognize the increasingflow of people and back offices movingto less expensive places in inland Cali-fornia or in states adjacent to California.Expect this trend to linger as problemssuch as traffic, aging infrastructure, andcost of living intensify in Los Angelesand San Francisco. The spillover eventu-ally extends to Seattle, Portland, Boise,and Salt Lake City, moving as far east asDenver. California has more thanenough staying power, but the state must


cope with retooling mature markets,while social services, education, andother government-related costs escalate.

Ups and Downs. Among major mar-kets, San Francisco makes the biggest leapin the ratings and Miami takes the largestfall. The entire Bay Area, including SanJose, seems poised for a rebound after thescorch-and-burn tech industry collapsefive years ago. South Florida holds ontopositive longer-term trends for growth,but condominium overbuilding poisonsimmediate forecasts. A proxy for lodgingmarkets, volatile Honolulu strengthensdramatically from a tourism upsurge andmore stable Japanese economy.

Sunbelt City Malaise. Atlanta,Houston, and Dallas remain buried inthe rankings’ lower quintiles. Denver andCharlotte register marginally better. Allsee ratings improvements, “but nothingto do cartwheels over.” Constructionrises to ever-stretching horizons, outstrip-ping demand no matter how prodigious.“Texas’s population may be growing, butthe markets are still oversupplied from20 years ago and they are still building.”Denver and Atlanta are the same story.“There is never enough growth to catchup and the oversupply doesn’t allow formuch appreciation.” Actually, growthtrends have been more lukewarm thanhot lately—well below 1990s peaks.Some office employment growth contin-ues, but at a slowed pace. Investorsalways look to time these markets and

put money to work. “Texas and Atlantaon a return basis are not so great,” says apension executive. “But there is alwaysproduct to buy and sell, which helpsmeet allocation targets.” The combina-tion of habitual market softness and cur-rent ample buyer demand appears tolimit upside on time-tested value-addstrategies in the current cycle. Houstonenjoys a temporary boost from NewOrleans’s misfortune.

Midwest Distress. Peek at the bot-tom of the market rankings. It’s a verita-ble congregation of Midwest cities. Jobsleak away, young people leave, the popu-lation ages and stagnates. Over the past30 years, these markets’ industrial back-bones have been slowly crushed by over-seas competition and technologicaladvances. Colder, uninviting climateschill interest from new businesses.Would your workforce prefer to live inMilwaukee or Detroit over La Jolla orRaleigh/Durham? The handful of over-seas manufacturers looking for U.S.beachheads gravitate to right-to-workstates in the South and Southwest whereunion labor rates won’t eat into profits.“The vast central region appears mired inpoor demographics with little immigra-tion or economic growth.” The remain-ing bedrock auto industry lists danger-ously. For investors, “there is low to nogrowth and low liquidity.” Chicagoslumps from top market status to justbehind high-plains neighbor Minneapolis/St. Paul. Both cities are buffered by adiversified group of nonmanufacturingbusinesses, but regional tribulationsthreaten to sap their vitality.

Airports and Ports. Globalizingtrends put premiums on access to worldmarkets. Cities with international trans-portation hubs have clear advantages overmarkets without. Businesses increasinglyrequire convenient access to airports withdirect flights to Europe and Asia. Nationalroutes or service to Canada and Mexicoare not enough anymore. Interior citieslike Dallas and Atlanta would be also-ranswithout their large airports and lineups ofinternational carriers. Charlotte, Tucson,Salt Lake City, and Portland, meanwhile,suffer from second-tier status—overseastravel means extra time connectingthrough airports with better internationallinks. Chicago is bolstered by O’Hare;Miami’s Latin gateway is anchored by itsairport. Foreign businesses base most U.S.operations near familiar destination pointswhere executives can come and go withless aggravation. Small wonder why moreconvenient coastal markets gain at theexpense of interior cities. The nation’sincreasing import traffic from Asia rein-forces the strategic importance of WestCoast ports at Los Angeles–Long Beach,San Francisco–Oakland, and Seattle.Northern New Jersey (Newark) solidifiesits standing as the most significant EastCoast industrial market, serving a majorport and international airport withnorth/south/west interstate access andcargo rail service.

Bright Lights, Big City. The brightlights, big city phenomenon, documentedrepeatedly in Emerging Trends recently,gains momentum. Young people continueto flock to large 24-hour business centersto launch careers, joined by empty nesterswho want greater convenience throughproximity to offices, restaurants, muse-ums, and stores. These burgeoning demo-


Businesses increasingly require convenient access to airports with direct flights to Europe and Asia.

graphic cohorts don’t worry about school-ing kids in better suburban districts. High-rise apartments, condominiums, andconverted lofts attract significant demandnot only in the more attractive traditional24-hour cities, but also in subcities andrevitalizing urban cores in areas surround-ing these cities. Regional housing pricesand rents soar. Arlington County in theWashington, D.C., area and Seattle’sBellevue submarket exemplify the trend.Now, even downtown Los Angeles showssigns of residential life after years as amoribund, post-nine-to-five ghost town.Infill housing in these “bright light”cities, especially near mass transit stops,will gain further appeal if energy pricesremain uncomfortably high.

Homebuilding Markets. Rankingsfor homebuilding markets generally followthe lead of Emerging Trends’ commercial/multifamily survey, but market ratingstemper as interviewees expect housingdemand to moderate. Southern Californiahousing markets—the nation’s mostexpensive and in-demand ones—dominatethe top spots. Orange County andRiverside/San Bernardino lead the survey.Scarce land and difficult entitlementprocesses almost guarantee successful proj-ects once completed—buyers gobble upwhatever gets constructed. Pricing headsout of sight—some interviewees wonderwhat will happen when mortgage ratesincrease and lenders pull back on interest-only loans and other financing structuresthat have allowed buyers to make deals.Defaults could soften these ultrapricey for-sale markets. “But there is not enoughhousing for people who want it.” Thehigh-growth Washington, D.C., metro-politan area sandwiches between tightnorthern California cities (Sacramento,San Jose, and San Francisco). Hot-growthPhoenix scores well, too, buoyed by

California out-migration. Florida main-stays Tampa and Orlando (high growth)also do well, but Miami falls most dra-matically in the survey—interviewees fearthe speculative condominium boom insouth Florida threatens to undercut pric-ing and values. Seattle moves up the listsignificantly, and New York City (the ulti-mate barriers-to-entry market) and its sub-urbs rank near the top again. After a siz-zling growth spurt, Las Vegas drops a fewnotches—again over concerns about con-

dominiums. Atlanta and Dallas no longerseem so high growth, and Chicago wob-bles. The rest of the Midwest trails badly.

The Gulf Coast will become a hotbedof activity, rebuilding from Katrina’s dev-astation. New Orleans was one of thesurvey’s lowest-ranking markets evenbefore the hurricane. It’s too soon toknow how many people displaced fromthe city will return, but homebuilderswill likely have no shortage of work.

Major MarketReviewSan Diego Prodigious absorption tightens theoffice market in this “great lifestyletown” where “everyone wants to live butcan’t afford it.” Overall vacancy headstoward 10 percent, but a significantamount of new development is under-way and could slow momentum towardequilibrium. Government offices, lawfirms, and accountants support down-town, while aerospace and biotech indus-tries shore up demand in northern sub-city nodes where the county’s center ofcommerce shifts toward LaJolla’s desirableexecutive neighborhoods. R&D is over-supplied, but the warehouse marketstrengthens—spec industrial developmentoccurs to the north and south, where landis less expensive. Limited land availabilityand solid job growth create a tight retailmarket—shopping center rental rateshit new highs. “The county is actuallyunder-retailed.” Warehouses rate a solid“buy.” Housing appreciation finally slowsafter setting a torrid pace. Expect furtherleveling. Fewer than 10 percent of locals


and Asia.

San DiegoLos Angeles (overall)

Orange CountyRiverside/San Bern.Los Angeles County

SacramentoWashington (overall)

Northern VirginiaWashington, D.C.

Maryland SuburbsTampa/St. Pete

PhoenixSan Jose

San Francisco (overall)San Francisco/San Mateo

Oakland/East BayOrlando

Honolulu/HawaiiSeattle

New York (overall)New York City

Newark/Northern N.J.Long Island

Westchester/FairfieldCharlotte

BostonAustin

TucsonLas Vegas

Portland, OregonRaleigh

Virginia Beach/Norfolk

5.975.935.836.065.875.795.775.765.745.965.245.635.625.615.575.515.495.275.115.106.505.505.055.004.974.914.594.574.494.374.20

DenverJacksonville

Atlanta (overall)Atlanta Suburbs

Atlanta CitySan Antonio

Minneapolis/St. PaulSalt Lake City

Chicago (overall)Chicago Suburbs

Chicago CityBaltimore

Dallas/Fort WorthNashvilleHouston

PhiladelphiaSt. Louis

Kansas CityMemphis

Miami (overall)Fort Lauderdale/W. Palm Beach

Miami/Miami BeachIndianapolisProvidenceMilwaukeeCincinnatiColumbus

PittsburghCleveland

New OrleansDetroit

Exhibit 3-2 Markets to Watch

0Abysmal

5Fair

10Outstanding

0Abysmal

5Fair

10Outstanding

7.067.067.607.337.227.026.977.407.137.026.786.746.746.717.026.906.616.606.556.546.886.366.256.216.306.256.236.176.166.056.026.00

Prospects for For-Sale Homebuilding


0

1

2

3

4

5

6

7

8

‘06 ‘04‘02‘00‘98‘96‘94

San Diego

7.0

can afford to buy the area’s median-priced house. The froth blows off thecondominium wave, too, although newdowntown housing helps create more ofa 24-hour environment, boding well forfuture vitality. “Horrendous commutingtimes result from people moving tofringe areas in search of better housingaffordability.” City corruption scandalscreate fiscal shortfalls and hurt bond rat-ings—costs increase for badly needednew infrastructure. The “miniature” air-port restricts the city’s ability to competeas a major commercial gateway.

Washington, D.C.“Stability personified,” this “core invest-ment” market benefits from low per-ceived downside risk—despite chronicpolitical noise about cutbacks and belttightening, the federal government keepsexpanding. “Huge velocity in govern-ment leasing leaves few large blocks ofspace available.” Lobbyists and consult-ants proliferate like weeds, and interna-tional firms increasingly want a D.C.presence. High tech blossoms again nearthe Pentagon and in other Virginia sub-urbs. Biotech strengthens its footholdaround Bethesda close to the NationalInstitutes of Health. The area continuesto enjoy excellent employment growthprospects and features high per-capitaincomes. Retail scores well. Hotels bene-fit from familiar, must-see tourist attrac-tions in addition to stepped-up businessactivity. Housing costs climb. Overall,the D.C. area remains “a top investorchoice, but hard to buy into since occu-pancies stay high and income growthstays strong, so you really pay up.” Someconcern grows about a peaking market—construction cranes signal new office

development and prices for existingbuildings rise well above replacementcost. “The area is much too expensive,yields are too low,” and decentralizingdefense agencies, concerned about home-land security, plan significant job trans-fers outside the Beltway. The Arlingtonand Alexandria submarkets could softenover this planned, six-year realignment.Traffic congestion worsens and antidevel-opment forces engage in pitched battleswith developers over sprawl. Suburbanareas along the Metrorail mass transitsystem look golden.

Los AngelesNew downtown skyscraper constructionresumes after a nearly 15-year hiatus.The lackluster business district suddenlyflickers with 24-hour life. Developerstake advantage of the demand for infillhousing, building almost exclusively resi-dential projects. With only 25,000 resi-dents, downtown L.A. has plenty ofroom to grow before becoming the newposter child for “the move-back-intrend.” The 25-plus condominium andapartment towers underway or on thedrawing boards may be “too much toofast.” Speculative investing in new units

and regional housing raise some con-cerns, although demand shows no letupanywhere in southern California.Downtown office vacancy remains miredin the mid teens. Any office revival alsorests on success with creating a residen-tial core to nullify the need for numbingcommutes from surrounding areas. Notsurprisingly, 24-hour subcity office nodeslike West L.A., Glendale, Burbank, andPasadena, convenient to prime bedroomcommunities, continue to fare much bet-ter than downtown. Orange Countyoffice “stays on fire.” Tenant expansions,not company relocations, drive leasinggains. “California is too expensive forcompanies to move in.” Overall, the LosAngeles area ranks a solid “buy” foroffice properties (see Exhibit 3-3). Hoteloccupancies stand near record highs. The“awesome” L.A.–Inland Empire areastrengthens its hold as the nation’s num-ber-one warehouse market, with vacan-cies hovering under 5 percent. The crushof Asian imports drowns the port andwarehouse districts in ship and truckcongestion. “Freeways and rail lines areoverwhelmed.” The gridlock leads togreater Inland Empire tenant demand forlarger distribution buildings. Land ishard to find for any type of develop-


In Los Angeles, land is hard to find for any type of development—prices skyrocket

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Washington, D.C.

6.9

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Los Angeles

6.5

ment—prices skyrocket in secondaryand tertiary locations. Retail prices are“crazy.” Traffic bottlenecks tie the area inknots—people desperately look to workcloser to home. Southern California’sfuture concentrates around stepped-uphigh-rise infill development and greaterdensity. Over the long term, the regionalskyline will look more vertical and proj-ects will be more mixed use in nature—downtown’s new residential towers arejust the beginning.

New York“Every night feels like New Year’s Eve;the city’s never looked better or seemedmore exciting.” The midtown office mar-

ket could be the nation’s strongest—leas-ing is “white hot.” Rents advance as ten-ants lock in new leases ahead of sched-ule, hoping to avoid future increasesin a sub–10 percent vacancy market.Landlords revel in pricing power. Like inD.C., office pricing in New York “is waytoo expensive.” For now, downtown“bumps along,” surviving off govern-ment tenant subsidies and incentives.Older office buildings convert to residen-tial uses, also helping firm occupancies.A new downtown mass transit hub willhelp eventually, promising to link LongIsland and New Jersey commuterrail/trains. But it is still years away fromcompletion. The financial district really


in secondary and tertiary locations.

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

6.3

New York

Exhibit 3-3 Office Property Buy/Hold/SellRecommendations by Metro Area

0 20 40 60 80 100

Sell %Hold %Buy %

51.16

48.75

40.91

40.38

40.26

35.38

33.33

30.88

28.13

27.94

25.37

24.53

20.00

17.39

10.42

23.26

17.50

31.82

26.92

24.68

35.38

40.35

22.06

35.94

30.88

25.37

33.96

40.00

30.43

20.83

25.58

33.75

27.27

32.69

35.06

29.23

26.32

47.06

35.94

41.18

49.25

41.51

40.00

52.17

68.75

Los Angeles

San Francisco

Boston

Seattle

Washington

New York

Miami

Phoenix

San Diego

Denver

Chicago

Houston

Atlanta

Dallas

Philadelphia


Exhibit 3-4 Retail Property Buy/Hold/SellRecommendations by Metro Area

0 20 40 60 80 100

Sell %Hold %Buy %

43.86

43.08

37.14

36.96

36.84

36.73

33.90

31.48

28.85

26.32

25.00

21.15

21.15

21.05

13.95

26.32

26.15

35.71

32.61

31.58

30.61

25.42

33.33

34.62

28.07

27.27

34.62

32.69

36.84

23.26

29.82

30.77

27.14

30.43

31.58

32.65

40.68

35.19

36.54

45.61

47.73

44.23

46.15

42.11

62.79

New York

Washington

San Francisco

Seattle

Los Angeles

Miami

Phoenix

Boston

San Diego

Denver

Houston

Chicago

Dallas

Atlanta

Philadelphia


doesn’t need all the new office spaceplanned to replace the World TradeCenter. More residential and retail wouldbetter enhance the fledgling 24-hourenvironment, spurred by the success atBattery Park City. The city’s coop/condo-minium markets have “been off thecharts.” But new development and con-versions of upscale hotels into chic hous-ing may be enough to level off pricing . .. finally. As guest rooms reconfigure intoliving and dining room suites, the lodg-ing sector booms—occupancies zoomnorth of 80 percent. New hotel construc-tion will heat up to fill the void. Retailalso scores well (see Exhibit 3-4).

PhoenixThe market’s story is “amazing” growth,growth, and more growth . . . in popula-tion, employment, and housing. Forecastssuggest the metropolitan area’s popula-tion could double to 7 million peoplein 20 years. Home affordability andlower-cost lifestyles draw middle-classCalifornians fed up with congestion andhigh housing prices. Construction andtourism also propel the local economy,and the retiree surge supports health care

industries. Reflecting the serviceemployment bent, per-capita incomestrail the national average. “Phoenix is 20years behind San Diego in creatingurban experiences”—downtown has lit-tle retail or residential and the sprawlmodel rules. More multifaceted subcitycores will evolve in Scottsdale, Tempe,and Mesa, eventually featuring high-riseresidential and mixed use. Following thesouthern California suburban agglomer-ation model, traffic woes will mount asdevelopment continues to spread. Watershortages also loom down the road inthis desert mecca, which has few barri-ers to entry.

San FranciscoThis premier 24-hour city shows signsof rebounding from its 2000 high-techimplosion. “It’s a dark-horse top mar-ket.” Financial and biotech firms expandoperations, and the state’s billion-dollarstem cell research initiative could be amajor boost. Office markets—bothdowntown and suburban—registervacancy declines from high to lowerteens, and rents increase modestly, espe-cially for prime Bay view space. Investors

pour in, anticipating “a nice recovery,”and drive up prices to Nob Hill heights.“Sentiment has turned around.” “Butthere is still ample oversupply.” In a tighthousing market with jobs increasing,apartments look sound (see Exhibit 3-5).Tourists never tire of this West Coastgem and neither do business travelers—hotel occupancies snap back. The ware-house sector firms more slowly thanexpected, but shipping activity shouldadvance as the local ports pick up over-flows from L.A. and Long Beach. Thecity’s future will turn more on interna-tional trade and links to Asia.

SeattleSeattle transforms into a 24-hour cityon the make—developers build moreintown housing, both apartments andcondominiums to meet the growingdemand from people who want to livecloser to work. “A fundamental shift hasoccurred.” The nearby Bellevue subcityfollows suit with a spate of mixed-useand apartment developments. Healthyjob growth sets the stage; the region’smajor employers—Microsoft andBoeing—expand and port activityincreases thanks to Asian trade. “Thecity is definitely on the global pathway.”Geographic barriers—water and moun-tains—restrain supply. A “slow andsteady” office market leaves recovery inrents “some time off.” Microsoft concen-trates activity on its own campus andWashington Mutual leaves a 900,000-square-foot leasing hole by moving into anew build-to-suit headquarters. “Biotechgrowth hasn’t materialized.” But institu-tional investors “have discovered themarket,” leaving “no stone unturned”and driving up prices. Still a lower-costalternative to California markets, the cityshould continue to enjoy consistent pop-ulation and income growth, propelled


In Seattle, all four major property types see strong investor demand and garner high “buy”

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

San Francisco

6.2

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Phoenix

6.3

by an increasingly diversified economy.All four major property types see stronginvestor demand and garner high “buy”ratings in the survey.

BostonInstitutional investors like this city’s 24-hour characteristics, abundance of col-leges and universities, intellectual talentpool, highly skilled labor force, andfinancial services backbone. Capitalinterest remains intense, especially fordowntown towers. But mergers and con-solidations have taken the starch out ofthe office market. Gillette’s purchase byProcter & Gamble promises anotherround of job slashing following on theheels of merger/consolidation/takeoversinvolving market mainstays JohnHancock and the Bank of Boston. “It’sbeen a double triple whammy.” Highbusiness costs and weak populationgrowth raise concerns, but financialfirms start to hire again and downtownvacancy edges down toward the lowerteens. The biotech-dependent suburbs“are a world of hurt,” struggling untilthat industry rebounds. Investors need toconsider playing the volatile R&D sectorfor cyclical upside. High heating bills

would crimp consumersand home sales during acold New England win-ter. Housing costs couldback off. Buyers eye theoffice market as a pre-ferred “buy” sector (seeExhibit 3-3).

MiamiThe only major marketto show a decline in thesurvey, south Floridasuffers from a heavy caseof condominium jitters.Interviewees fear ram-pant speculation sets thestage for a “crash” or“debacle” that will over-supply multifamily mar-kets. A high-profile con-dominium developeradmits: “We may gethurt.” Miami ranks deadlast for buying apart-ments (see Exhibit 3-5).Aside from “bubbly” res-idential, other propertysectors look extremely

solid. Miami’s international gateway con-tinues to draw office tenants engaged inLatin American trade. “Latin-based com-panies make Miami their number-oneheadquarters choice.” Office vacanciescould drift into single digits and “develop-ment is under control.” Passage of CAFTAbodes well for increased import/exportactivity and the local warehouse markethums. Hotels thrive off international busi-ness and tourism. South Beach is still pop-ular with the global jet set. Retail vacancyis miniscule. Miami’s growing importance


ratings in the survey.

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Seattle

6.1

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Boston

5.8

Exhibit 3-5 Apartment Property Buy/Hold/SellRecommendations by Metro Area

0 20 40 60 80 100

Sell %Hold %Buy %

52.70

44.93

39.22

38.71

37.70

32.91

28.13

27.87

20.93

20.00

19.64

19.05

16.92

15.52

12.28

27.03

26.09

33.33

30.65

34.43

26.58

34.38

26.23

30.23

34.00

35.71

26.98

32.31

31.03

21.05

20.27

28.99

27.45

30.65

27.87

40.51

37.50

45.90

48.84

46.00

44.64

53.97

50.77

53.45

66.67

San Francisco

Washington

Seattle

New York

Boston

Los Angeles

Denver

San Diego

Philadelphia

Houston

Chicago

Phoenix

Atlanta

Dallas

Miami


vis-à-vis Latin American commercial cap-ital can only accelerate future marketexpansion. Unlike Orlando and Tampa,Miami/Fort Lauderdale is largely builtout—the Everglades and ocean constrictnew supply. More vertical infill redevel-opment promises to urbanize the entirearea over time.

DenverA quality of life magnet, Denver strug-gles to sustain its core business environ-ment. Local banks and financial compa-nies “get blown out by M&A.” The city’sonce-formidable telecom beachhead getslost in industry consolidation. “Everyonewonders what will happen to Qwest,”which is ripe for takeover. Entrepreneurs,close to ski centers and mountain biketrails, incubate small- and mid-cap com-panies, “which always seem to getbought up.” Boulder’s fractured high-tech market regains momentum as ahub for defense and homeland security.Employment growth remains solid, “butunspectacular.” Office hobbles along inoversupply. The multifaceted downtownLoDo market stands out as the excep-tion. Bursting with new residential andstreet life, this expanding 24-hour dis-

trict boasts low vacancies. It’s alsoDenver’s light-rail hub—people increas-ingly look to mass transit alternatives toavoid choked commuter highways. “Thecloser you’re invested to LoDo, the betteryou’re doing.” Multifamily improves andretail is decent, but “the market is nottaking off like a rocket ship.”

ChicagoThis solid 24-hour city stumbles as othermarkets resuscitate. Office developmenthas continued despite “poor job growthand weak demand.” Tenants take advan-tage and expand into new space at bar-gain rates, leaving older buildings on theropes. It’s a testament to what could hap-pen in other markets if new constructionramps up unnecessarily. “Local govern-ment is too development friendly anddowntown has too many parking lotsites.” Corporate consolidations alsohurt—the city no longer has a money-center bank headquarters. “Office ratesare about where they were in the eight-ies.” Investors “overpay” for Loop andnear Northside towers. Suburban officemarkets are “scary” too. “Once dead,they are now just in critical condition.”Housing looks “overpriced” and condo-

minium development gets way ahead of“move-back-in” trends.” Some for-saleluxury units turn into rental pumpkins.But multifamily firms and landlordsbegin to raise rents in the dependableindustrial market around O’Hare.

AtlantaGo-go growth days may be over. LikeDallas, “this older Sunbelt city could be surpassed by the next generation—Phoenix.” The local economy flounders,at least temporarily. See what happenswhen sprawl and congestion strangleappeal for corporate relocations.Unemployment actually increased duringpart of 2005, office absorption trailsnational trends, and Delta Airlines’ pre-carious state hits a low note. What’sworse—cranes start appearing. “Forgetit. Too much land, too many sites.” “Adeveloper lines up on every corner.”“Tenants play musical chairs with own-ers.” Infrastructure costs rise to fix pastplanning mistakes for new roads andsewers. Resulting tax bill hikes make thearea less cost competitive. Despite mar-ket softness (office vacancies in the highteens), investors pour in to make deals at


A quality of life magnet, Denver struggles to sustain its core business environment.

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

5.8

Miami

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

5.3

Denver

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

5.3

Chicago

core-styled cap rates, feeding nascentdevelopment fires. The best commercialmarkets center in Midtown andBuckhead, both urbanizing areas with24-hour characteristics and high-qualityresidential neighborhoods, includingcondominium towers and apartments.MARTA subway access also helps thesedistricts: “People are willing to pay forextra convenience.” Demographic shiftscontinue to favor the South, and Atlantaremains strategically positioned to bene-fit, especially with its crossroads locationand world-class airport. But the marketneeds to fashion more multifacetedurban districts like the new AtlanticStation development, and find a way toexpand mass transit. For now, investorscan’t get excited.

Houston New Orleans’s pain will be Houston’sgain, at least in the short term. Thisenergy-industry city has never approachedequilibrium since its early-1980s construc-tion binge. But now Mother Nature shiftsfortunes. Refugee businesses and popula-tion from the Katrina catastrophe willhelp eat into chronic oversupply in office

and apartments. The hur-ricane accelerates a long-term trend—Houston’scoaxing energy-relatedcompanies from theCrescent City. Warehousemarkets also capture redi-rected port traffic fromNew Orleans and otherdamaged Gulf Coast har-bors. Houston is a top“buy” market for ware-houses (see Exhibit 3-6).But, like Atlanta andDallas, the city has hadtrouble igniting enoughemployment growth tokeep up with never-end-ing development.

Philadelphia“Limps along.” Two newoffice towers add 2 mil-lion square feet in andaround Center City,pirating tenants out ofexisting space. Watchvacancy ratchet up in


0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Atlanta

5.1

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Houston

5.1

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

Philadelphia

5.0

Exhibit 3-6 Warehouse Property Buy/Hold/SellRecommendations by Metro Area

0 20 40 60 80 100

Sell %Hold %Buy %

50.68

45.28

41.30

40.00

38.98

38.78

36.36

33.33

32.76

32.69

32.14

28.33

26.92

26.67

21.43

26.03

16.98

30.43

22.22

37.29

30.61

40.00

46.97

25.86

30.77

37.50

36.66

38.46

43.33

23.81

23.29

37.74

28.26

37.78

23.73

30.61

23.64

19.70

41.38

36.54

30.36

35.00

34.62

30.00

54.76

Los Angeles

San Diego

Seattle

Houston

Washington

Miami

New York

San Francisco

Phoenix

Chicago

Boston

Denver

Dallas

Atlanta

Philadelphia


this low-growth market, hurt by recentpharmaceutical company cutbacks. Taxabatements encourage new residentialdevelopment and conversions in CenterCity, a key to a possible market renewal.Cheap real estate attracts some new resi-dents and businesses hit by sticker shockin Northeast metropolitan areas.

Dallas“Despite 25 percent vacancy, they can’tquit building.” “Investors need to learnthat too much new construction killsvalue harder and faster than any slow-down in demand.” Locals argue thatmuch of empty downtown space is soobsolete “it shouldn’t be counted.” “ClassA downtown towers lease much better”and most of the new building is confinedto perimeter areas. Job growth has revivedto moderate levels, as national companiestake advantage of significant air freight,cargo, and logistics capacity at theMetroplex’s superior airports. UPS, Fluor,and Celanese announce the basing of new local operations. Home prices stay well

below the national average. Ample hous-ing alternatives and new development capappreciation potential.

Smaller MarketProspectsMost interviewees remain skeptical aboutthe risks/rewards for investing in second-ary and tertiary markets. “Avoid—theyhave no employment growth, no immi-gration, no in-migration, and no clearexit strategies.” Value-add investors, shutout of opportunities in larger markets,

see reasonable risk: “You’ll be OK if youbuy at a low-enough basis and figure alocal buyer will eventually take you out.”But more investors, pushed along bycompetition for product amid swells of capital, “fail to differentiate yieldsbetween primary and secondary mar-kets.” “Trophy-looking buildings nowtrade in Minneapolis, St. Louis, andCleveland at premiums, because theytake pretty pictures.”

Sacramento retains sturdy state capi-tal appeal—lots of government jobs andgovernment-related employment, servinga veritable nation-state—and a stronghousing market with more moderatehome prices than nearby San Franciscodoesn’t hurt. Las Vegas booms offCalifornia out-migration and tourism


Most interviewees remain skeptical about the risks/rewards for investing in

0

1

2

3

4

5

6

7

8

‘06‘04‘02‘00‘98‘96‘94

4.9Dallas

in everybody’s favorite glitzy sin city.Escalating house prices are still a frac-tion of those in Orange or San DiegoCounty, but condo-mania may be over-played. Most new arrivals can’t affordsome of the high-end product. Also, thelocal economy is a one-trick pony sus-ceptible to a quick downturn, especiallyif consumer hands turn cold. Will highenergy costs curtail weekend jaunts frompoints east and west to the dice tablesand Celine Dion shows? Honolulu bene-fits from improving hotel, travel, andresort industry prospects. Austin easilyoutranks other Texas markets—it’s a uni-versity town as well as a state capital witha vibrant tech-oriented economy. Butthis increasingly influential city is not acommercial crossroads like Dallas. SanJose revives from recent tech-wreck trou-bles as Silicon Valley company prospectsimprove. Orlando and Tampa havelower-grade condominium conversionfever than south Florida markets.Without Miami-like barriers to entry,

these expanding cities behave more liketraditional high-growth Sunbelt markets.Tourism, retirement, and health care pro-vide resilient underpinnings. Jacksonville’sport becomes more strategic. Althoughcooler than other Florida markets, thecity lies directly in the prime populationgrowth path headed to the palm coasts.Attractive Portland (Oregon), a smaller24-hour market, is slightly off the beatentrack. Carolina corridor cities—Raleighand Charlotte—continue to percolatewith incoming retirees and relocatingSnowbelters attracted to cheap housingand a temperate climate. Colleges anduniversities support the ResearchTriangle, while two of the nation’s largestbanks call Charlotte home. Even withoutKatrina, New Orleans ranks near the sur-vey bottom. Rebuilding efforts will fun-nel a lot of capital into the city, but thelosses are staggering. While the city’sunique convention destination aura maybe restored around the distinctive FrenchQuarter, some Poydras Street corporateoperations may never return. . . and youknow the Midwest story by now!


secondary and tertiary markets.

Propertyin

Propertyin

“Aside from hotels,

property sector value increases

have derived from cap ratecompression, not operations.”

For 2006, Emerging Trends interviewees predict thatinvestment prospects will improve slightly over last year’ssurvey across all major property sectors and generally

remain “fair” to “modestly good” (see Exhibit 4-1). The spreadbetween the leading and trailing categories narrowed to 0.7—hardly a significant difference. In the 2003 survey, a 2.4 top-to-bottom spread existed. Last year, the spread was nearly 1.0. Allsectors will remain in or reach relatively good supply/demandbalance, reinforcing views that markets will tighten and helpincrease property cash flows. Interviewee ratings (on a scale of zero [abysmal] to ten [outstanding]) register only smallimprovements from last year for the favorite income-generatingcore sectors: warehouse (6.1), neighborhood shopping centers(6.0), and moderate-income apartments (5.9). Full-servicehotels (6.1) make the biggest leap, jumping to the survey’s topspot, while limited-service hotels returned to familiar territory,ranking last. Lack of recent development insulates the full-serv-ice category, while limited-service hotels are more vulnerable tooverbuilding. Downtown (5.5) and suburban (5.4) office also


score relatively solid gains, but remain settled in the rankings’lower rungs. All three retail sectors dropped in the investmentrankings, indicating an expected falloff in value gains.

Hotels, Warehouses, and NicheSectors on TopFull-service hotels’ primacy marks the first time the categoryhas led Emerging Trends rankings. Investors hungry for alphaupside predict more revenue growth from upscale lodging cate-gories than any other property sector. Multifamily yields willbe compromised by extremely low cap rates, while office andindustrial rents recover slowly. Retail sectors never experiencedany softness after 9/11 or the “tech wreck” and appear to have

c h a p t e r 4

PerspectiveTypes

exhausted most of their appreciation potential after several sen-sational years of performance (see Exhibit 4-2).

Given capital demand for product, cap rates have declinedacross all property sectors since last year’s survey—apartmentsand regional malls register the lowest deal rates, while hotelsscore the highest (see Exhibit 4-3).

Interviewees appear uniformly uninspired about buy oppor-tunities in primary property categories. Land, full-service hotels,warehouses, and moderate-income apartments entertain passinginterest, but investors put checkbooks away after that. Pricing istoo rich for most appetites. Sell signals proliferate, especially inthe office, retail, and high-income apartment sectors.

In markets like southern California, Phoenix, and even theManhattan financial district, investors view condominium con-version and development opportunities as higher and betterland uses than either office or retail. “In housing-constrainedmarkets, retail rents can no longer keep up with housing.”

Many niche properties—seniors’ housing, master-plannedcommunities, urban mixed use, and resort hotels—score higherinvestment ratings than the major property sectors (see Exhibit


Sell signals proliferate, especially in the office, retail, and high-income apartment sectors.

0Abysmal

5Fair

10Outstanding

Supply/Demand BalanceDevelopmentInvestment

Exhibit 4-1 Prospects for Major Property Types in 2006


Full-Service Hotels

Warehouse Industrial

Neigh./CommunityShopping Centers

Multifamily Rental– Moderate Income

Power Centers

R&D Industrial

Downtown Office

Suburban Office

Regional Malls

Multifamily Rental–High Income

Limited-Service Hotels

6.135.416.05

6.116.196.25

6.016.226.38

5.875.535.99

5.765.736.20

5.745.435.63

5.554.345.31

5.474.605.18

5.454.306.18

5.435.455.64

5.415.145.25

Exhibit 4-3

SpreadBid Ask (Basis Points) Deal

Apartments–High Income 6.5 6.0 50.0 6.0Regional Malls 6.5 6.0 50.0 6.5Apartments–Moderate Income 7.0 6.0 100.0 6.5Neighborhood/Community Centers 7.0 6.5 50.0 7.0Downtown Office 7.5 6.5 100.0 7.0Power Centers 7.5 7.0 50.0 7.0Warehouse Industrial 7.5 7.0 50.0 7.3R&D Industrial 8.0 7.5 50.0 8.0Suburban Office 8.0 7.0 100.0 8.0Hotels–Full Service 8.4 8.0 40.0 8.0Hotels–Limited Service 9.0 8.5 50.0 9.0

Source: Emerging Trends in Real Estate 2006 survey; median responses.

Capitalization Rate Characteristicsin 2005

Exhibit 4-2

Percent

Land 10.87Hotels–Limited Service 8.54Hotels–Full Service 8.53R&D Industrial 7.86Suburban Office 7.70Neighborhood/Community Centers 7.69Power Centers 7.64Warehouse Industrial 7.54Apartments–Moderate Income 7.53Downtown Office 7.47Apartments–High Income 7.24Regional Malls 7.05


Total Expected UnleveragedReturns 2006

4-4). Generally, interviewees hope these property types can skirtthe capital wave and offer better investment values. But nichesectors tend to offer shallow selection and fewer opportunities.Outsized investor interest has already bid up pricing, and onlyunderscores the lack of attractive deals in the traditional prop-erty categories.

Development Gearing UpDevelopment prospects also advance across all sectors, led bywarehouse (6.2) and neighborhood centers (6.2). These scoresedge ahead of sector investment ratings—pricing for existingproperties in these two categories stands well above replacementcost, enticing builders. But any new construction may be pre-mature in many markets. Except in leading southern Californiaand northern New Jersey markets, industrial vacancy ratesdecline slowly and may stay above average, while consolidationamong supermarket chains shadows grocery-anchored retail.Moderate-income apartments could be poised for new develop-ment, too, if a combination of interest rate advances and highhousing costs push more renters into the market. Relativelysoft office markets argue against building new product almosteverywhere. Most developers long ago gave up on planningnew regional malls. Securing anchors and entitling large tractsbecomes increasingly difficult. Given rising occupancies andstrong revenue gains, new full-service hotel construction almostcertainly will get on track in 2006.

Infill and intown housing again score the highest develop-ment prospects. Traffic congestion, gasoline costs, and thegrowing inconvenience of suburban lifestyles propel many peo-ple back toward urban and subcity cores. The empty nester and“bright lights” echo boomer syndromes also help fuel thistrend, which shows no signs of abating.

Traditional single-family home development will continueapace. For all the move-back-in activity, cheaper housing islocated in suburban and exurban areas, where the majority ofAmericans still want to live. But rising mortgage rates coulddampen activity overall and gas pump costs may temperdemand in perimeter areas when buyers calculate drivingexpenses and time lost in commuting. Rising construction-related costs and expected construction material shortages couldshort-circuit some homebuilding activity. Second and leisurehomes should maintain buyer momentum from growing num-bers of baby boomers, entering prime wealth accumulationyears and eyeing retirement.


t sectors.

0Abysmal

5Fair

10Outstanding

Supply/Demand BalanceDevelopmentInvestment

Exhibit 4-4 Prospects for Niche and Mixed-UseProperty Types in 2006


Seniors’/Elderly Housing

Master-PlannedCommunities

Urban Mixed-UseProperties

Resort Hotels

Student Housing

Mixed-Use Town Centers

Lifestyle/Entertainment Centers

Multifamily Rental–Tax Credit

Master-Planned Resorts

New UrbanistCommunities

HotelsStrengthsHotels make a “roaring comeback,” boosting all segments.“We’re knocking out the lights.” Occupancies race toward 70percent, well above (55 percent) break-even levels. Lenders hadredlined most new construction, allowing full-service marketsto firm and now revenues to catch fire. Condominium conver-sions also helped constrict supply in some major markets—owners cash out of luxury lodging and convert into opulent liv-ing. Corporate travel heads back to a pre-9/11 pace and theweak dollar entices foreign tourists. “It’s hard to find roomsagain,” especially in full-service central business district hotels.At luxury hotels in major markets, $300–$400 room tabs areback, not including pricey extras for room service and breakfastcoffee. “Sir, here is your [$20] basket of fresh-baked muffinsand English breakfast tea.” Creative surcharges generate healthyrevenues for everything from restocking minibars to bed turn-downs and gym use. “That towel at the pool will cost youextra!” But at these prices, does it really matter to guests payingthe tab? Even limited-service properties show impressive gains.

WeaknessesEnergy prices deliver a wild card, potentially affecting lodgingdemand. Higher airfares and gas prices could curtail some busi-ness and tourist travel or at least decelerate growth trends. Anavian flu outbreak could also chill the sector. No surprise, rav-enous capital bids up property pricing—bargain hunters are leftwanting. During the 9/11 downturn, many owners deferredmaintenance and capital projects. Some properties need costlymakeovers, which require increased investment and slash rev-enues when rooms temporarily go out of inventory.

Best BetsResorts and destination cities show the most punch. The luxurysector benefits from long development lead times. Existingproperties have significant current pricing power, which por-tends excellent cash flow growth. Some major cities appear sup-ply constrained, particularly New York and Los Angeles. Bostonand San Francisco should improve. Warm weather destinationsin Florida and Hawaii also excel.

Sell limited-service hotels into strong buyer demand. Theseproperties are too easy to build. If development gears up asexpected, new competition will eat into occupancies, revenues,and eventually values.


Hotels have legs as long as the economy expands.

0

3

6

9

12

15

18

60

62

64

66

68

70

Exhibit 4-5 Hotel Construction andOccupancy Rates

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Exhibit 4-6 Hotel/Lodging Total Returns■ Construction (Billions $)

Cons

truct

ion

(Bill

ions

$)

Occupancy Rate %

Occu

panc

y Ra

te %

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*

2006

*

2007

*

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*

■ NAREIT Lodging/Resort Returns ■ NCREIF Hotel Returns

Sources: National Council of Real Estate Investment Fiduciaries (NCREIF),National Association of Real Estate Investment Trusts (NAREIT).

*2005 NCREIF data annualized from second-quarter 2005. 2005 NAREITdata year-to-date as of September 30.

Sources: U.S. Bureau of the Census, Economy.com, Torto Wheaton Research.

AvoidLimited-service product in second-tier cities and suburban mar-kets typically play a weak hand. Interviewees consistently urgecaution. Most institutional investors avoid altogether. Manyproperties have deferred maintenance issues and need capitalinfusions. “Watch for hidden costs.” Over time, demand willbe spotty and pricing power is more difficult to sustain.

Hotel investors need to create alignment of interests withmanagers, often through joint ventures. This specialized sectorrequires reservation flow and operations economies, but investor/operator relationships have never been easy. Turnover in flagsconfuses travelers and can disrupt service. Inexperienced capitalwould be wise to spend elsewhere.

DevelopmentLenders get more comfortable—development financing is avail-able again. New construction will begin to add supply by year-end 2006 and into 2007. By 2008, everybody will bemoandevelopment excess, especially in limited-service segments.Owners in luxury and resort segments will continue to convertsome rooms to residential as long as the market for extravagantpieds-à-terre and getaways holds up. Adjacent land tracts areripe for leisure home development. Buyers will pay extra toavail themselves of resort amenities.

OutlookHotels have legs as long as the economy expands. “It will beanother two years before a new round of development kicks uproom supplies” and slows revenue growth. Terrorism hangs inthe background as an ongoing risk, but all forecasts need toconcentrate on the direction of fuel prices. Hotels are the mostsensitive and volatile property segment. Any souring in demanddrivers will hit bottom lines immediately.

IndustrialStrengths“Good, steady, and boring,” warehouses are sound “low beta”investments. “Rents don’t move much,” but exceptional institu-tional appetites for this classic core sector ensure ready exitstrategies and excellent liquidity. Economic growth spursrecent vacancy declines and rents should increase “modestly”in 2006—the sector is “clearly in recovery mode” after nationaloccupancy levels had fallen to historic, though manageable,sub–90 percent lows.

WeaknessesCap rate compression has pushed pricing well above replace-ment cost, especially in supply-constrained California markets,where Pacific ports gorge on imports from China and the rest


Exhibit 4-7 Prospects for Full-Service Hotels in 2006

Prospects Rating Ranking

Investment Modestly Good 6.13 1stDevelopment Fair 5.41 7thSupply/Demand Balance Modestly Good 6.05 5th

Expected Unleveraged Returns 2006 8.0%Deal Cap Rate 2005 8.0%

Buy Hold Sell35.15% 38.41% 27.44%


Exhibit 4-8 Prospects for Limited-Service Hotels in 2006


Investment Fair 5.41 11thDevelopment Fair 5.14 8thSupply/Demand Balance Fair 5.25 10th


Buy Hold Sell22.0% 28.9% 49.1%


of Asia. In some major industrial hubs, developers step up con-struction of higher-quality, more flexible, big-box distributionfacilities. They can offer lower rents, undercutting existingproduct that may be at a competitive disadvantage, if configu-rations cannot accommodate rapidly evolving shipping tech-nologies and tactics. Just-in-time manufacturing continues toreduce demand growth and control inventories. Changing ship-ping logistics strategies make it more difficult to keep up withtenant needs. Property management becomes more specialized,especially in the prime international transport centers. Big boxperforms better, but bears greater risk from the large single ten-ants they attract—bailouts can sink returns. Small deal sizemakes for inefficient investing. Acquisition packages can buildportfolios more quickly, but sellers often take advantage, mix-ing in “cats and dogs” with premier properties. For manyinvestors, the opportunity to buy a good asset outweighs reluc-tance about weaker sisters.

Best BetsMost interviewees sing a familiar tune: own big-box warehousein the small number of airport and seaport markets serving theglobal transport routes. The “same old list” includes northernNew Jersey (Newark Airport, turnpike, New York ports), LosAngeles–Inland Empire, San Francisco, Seattle, and Miami.Core buyers pay premiums in these places for highly pre-

dictable cash flows. The volume of imports inundating majorWest Coast ports helps expand warehouse demand at second-ary harbor destinations including San Diego, Houston,Washington/Baltimore, Charleston, and Jacksonville. Houstonalso gains from New Orleans’s travail.

AvoidAtlanta and Dallas, key airport/interstate nexuses remain over-supplied—“it’s too easy to build.” Other interior secondary andtertiary markets get removed from distribution chains. “It’s atale of the two coasts.” Even Chicago “isn’t on as many buyerlists,” although it holds onto a top rating thanks to O’Hare.While lower-ceiling traditional storage-style warehouse space“can work” in smaller regional markets, owners can’t competeeffectively in the major hubs. There, major shippers use facili-ties as well-oiled redistribution points driven by complex logis-


If you’re flummoxed about whether to buy existing properties or develop warehouses today, new construction or redevelopment strategies get the nod.

0

50

100

150

200

250

0

2

4

6

8

10

12

Exhibit 4-9 Industrial Completions andAvailability Rates

■ Completions (msf) Availability Rate %

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Source: Torto Wheaton Research.

*Forecasts.

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Exhibit 4-10 Industrial Property Total Returns

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*

■ NCREIF ■ NAREIT



Com

plet

ions

(msf

)

Avai

labi

lity

Rate

%

tics technologies now including computer chips embedded inshipment palates, which can be tracked by satellites and redi-rected at a moment’s notice. Properties need large turning areasfor supersized tractor trailer trucks and large open spaces toaccommodate movement of goods quickly from incomingtransport to outgoing.

DevelopmentIf you’re flummoxed about whether to buy existing propertiesor develop warehouses today, new construction or redevelop-ment strategies get the nod given high pricing and low yieldson premium existing space. Developers can build for less andprofitably flip to institutional buyers. Finding suitable tracts atreasonable prices can be difficult in the leading markets unlessat fringe locations. But port and traffic congestion in theseareas lead many shippers to institute “just-in-case” strategies inthe event “just-in-time” cannot deliver. They store product insatellite locations outside the central market hubbub in theevent of any shortfalls from delays. Understanding and meetingthese tenant needs can determine project success. Warehousesupply/demand never gets too “out of whack,” because of shortproject completion time frames. Developers can pull backquickly, if markets appear to overheat or tenant demand sud-denly diminishes.

Warehouse OutlookThe industrial warehouse sector should “plug along as usual,”tracking expected economic expansion. Expect steady improve-ment across most markets, helping stabilize values at or near

rich levels. Development will temper the rate of vacancydeclines in some areas and may undercut opportunities for renthikes. Buyer demand never seems to let up. These bond-plusinvestments may act more like bonds in the medium term.

R&D OutlookOff most investor shopping lists, the historically volatileresearch and development/technology sector offers a moreopportunistic risk/return profile than the more staid warehousecategory. Core players typically steer clear—exit strategies aremore limited and the sector is less liquid. “Whom do you sellto?” Tenants are specialized and quirky, often with atypical lay-out requirements. Typically credit-risk startup enterprises, theymay transform suddenly into a Google or more likely just col-lapse. High vacancies from the 2000–2001 tech industrymeltdown continue to plague most R&D markets, but turn-arounds can be abrupt. The vanguard Silicon Valley shows signsof life and if computer firms, chip makers, and biotech compa-nies finally rebound, demand in other markets could sharplyincrease. “It will happen. It’s just a matter of when.” Even inR&D, good buys will be hard to uncover given capital interest.Still, this sector has more upside than most. Just be prepared tosell holdings before the new Bill Gates, who signed that biglease, turns out to be just another John Smith.


new construction or redevelopment strategies get the nod.

Exhibit 4-11 Prospects for WarehouseIndustrial in 2006


Investment Modestly Good 6.11 2ndDevelopment Modestly Good 6.19 2ndSupply/Demand Balance Modestly Good 6.25 2nd


Buy Hold Sell32.2% 37.7% 30.0%


Exhibit 4-12 Prospects for R&D Industrial in 2006


Investment Modestly Good 5.74 6thDevelopment Fair 5.43 6thSupply/Demand Balance Modestly Good 5.63 8th


Buy Hold Sell27.1% 34.4% 38.5%


ApartmentsStrengthsMany “bullish” interviewees point to a convergence of marketforces set to boost occupancies and rents throughout the yearand into 2007. These include stratospheric home prices, higherhomebuilding costs, rising mortgage rates, satisfactory jobgrowth, an incoming demographic tide of echo boomer renters,and condominium converters continuing to take product offthe market. “More people can’t afford to own and will have torent.” Investors concede daunting cap rate declines, “which defyfundamentals” but embrace the sector’s lack of volatility fromsteady rent flows and liquidity from unquenchable buyerdemand. Concessions abate in most markets.

WeaknessesAlthough some interviewees suggest a soft-landing “winddown” to the recent spate of condominium conversions anddevelopment, most express greater concern. “The condo craze”could come back to haunt some high-end apartment markets

where speculators—buying multiple units to flip in a risingmarket—have dominated recent buyer demand and incited“insane” investor and builder activity. Some converters buymultifamily properties for premiums 20 to 30 percent aboveapartment investors. “I love condo converters,” says a value-addportfolio manager, who has been selling out of apartments. “Itwould take an idiot not to see what will happen in southFlorida.” But converters and developers also steam up othermarkets. Many “babes-in-the-woods” speculators—individualinvestors jumping on the real estate bandwagon—will getstretched on carrying costs if their units do not resell quickly.

The domino effect kicks in when new condominium productfails to move and bad press about speculator remorse unnervesother buyers. Units then get turned back to rentals, softeningapartment supply just as affected markets should tightentoward equilibrium from increased demand. Low-end condo-minium projects could turn sideways too when “starter-home”buyers get stretched on rising mortgage payments—lendershave been lax on financing terms with all sorts of condominium-borrower-friendly gimmicks that reduce initial payments buthave various costly balloon features. Low cap rates, driven down


Apartment investors need to stay away from markets susceptible to condo-rental reversions.

0

50

100

150

200

250

300

350

400

0

2

4

6

8

Exhibit 4-13 Apartment Completions andVacancy Rates

■ Completions Vacancy Rate %

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*20

06*

2007

*

Source: REIS (Includes Top 50 U.S. Markets).

*Forecasts.

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Exhibit 4-14 Apartment Property Total Returns

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*




Com

plet

ions

(tho

usan

ds o

f uni

ts)

Vaca

ncy

Rate

%

by converters, mean recent apartment acquisitions “have no riskpremium” built into underwriting. At these prices, “forget aboutappreciation over a five- to seven-year holding period.”

Best BetsDispose of weaker holdings, selling into the continuing buyerwave for as long as it lasts. Meanwhile, consider “rifle shot”investments for value-add gains. Look for B or B-minus unitsthat can “be dressed” up inexpensively into B-plus apartments:“slap on a fresh coat of paint, plant new landscaping, and retilethe swimming pool.” Northeast barrier-to-entry markets remainmost compelling and resistant to any cap rate decompression—building new product is difficult and premium housing costssustain consistently strong renter demand. Hold some powderand “buy busted-up condo deals.”

AvoidLate-in-the-game condominium conversions and developmentcould end badly in certain markets. South Florida and Las Vegas“may be disasters waiting to happen.” Southern Californialooks ripe for a lesser correction—“prices are unsustainable”—and projects in Phoenix and Chicago could be vulnerable—overbuilding may drop values. New York and Boston sufferfrom excessive capitalization, “but don’t look like bubbles.”Apartment investors need to stay away from markets susceptibleto condo-rental reversions.

DevelopmentFor now, returns on new multifamily product generally pencilout ahead of dearly priced acquisitions. Most “low hanging”condominium conversions have been completed successfullyand some developers join the party just as housing marketdemand starts to brake. “It’s out of control.” The optimisticview suggests that new units may “take longer to sell.” Apart-ment builders need to exercise greater caution—improvingrenter demand may not support construction where conver-sions tumble back into inventory.

OutlookFor 2006, multifamily will be the bellwether for other sectors.If development imbalances can be controlled, increased num-bers of renters should bolster occupancies and augment cashflows, creating a full-blown landlord’s market. These improvedsupply/demand fundamentals will shore up values as interestrates increase. At least in some markets, condominium excessescloud prospects for a strong recovery. Anyway you cut it, yieldslook slim. Sellers should do better than buyers.


Exhibit 4-15 Prospects for Moderate-IncomeApartments in 2006


Investment Modestly Good 5.87 4thDevelopment Modestly Good 5.53 4thSupply/Demand Balance Modestly Good 5.99 6th


Buy Hold Sell31.7% 26.4% 41.4%


Exhibit 4-16 Prospects for High-Income Apartments in 2006


Investment Fair 5.43 10thDevelopment Fair 5.45 5thSupply/Demand Balance Modestly Good 5.64 7th


Buy Hold Sell15.5% 30.4% 53.6%


OfficeStrengths Recovery gains momentum . . . finally! Vacancies will continueto decline nationally and rental increases will extend beyondNew York, Washington, D.C., and southern California mar-kets. Tenant concession packages also become more economi-cal. Vacancy suddenly looks like an asset for writing up valuesin markets with decent job growth. Development activity bearswatching—new construction has been restrained.

WeaknessesAlthough office “looks better than it has for a long time,” thesector is “no house of fire.” As five-year leases inked at markethighs roll over, property cash flows take a hit. At least, ownerscan anticipate marking up rates from leases executed in ensuingweaker years . . . . Landlords curse corporate productivity gains,which just keep advancing. Technology, alternative workplacestrategies, and outsourcing to freelancers as well as cheap over-seas workers dampen office demand growth, slowing rebounds

in occupancies and lease rates. Only market timers scored reallywell in office over the last cycle—“rents and vacancies don’tlook much different from ten years ago.” Bank and financialcompany consolidations hurt two stalwart markets—Chicagoand Boston. Investors “need to accept stabilized vacancy atabout 10 percent. Five percent to 7 percent is too low givenjob losses, rightsizing, downsizing, and outsourcing.”

Best BetsVoracious capital demand eliminates most chances to buy lowand ride recovery to a cyclical zenith. Current pricing alreadyanticipates peak rents in many markets. Selling nonstabilizedassets makes more sense (cents), especially when buyers bet thefarm on resounding future performance. Why take a chance thattenant demand disappoints? Well-located, prime assets shouldmake decent holds. Coveted properties feature more flexible floorplates to accommodate changing tenant requirements and techneeds. Best hold markets boast good jobs creation—Washington,D.C., New York, southern California, and south Florida—and/orare supply-constrained—San Francisco and Boston.


If development gets stoked too soon, office markets would backslide given comparatively fragile tenant demand.

0

20

40

60

80

100

120

-100

-80

-60

-40

-20

0

20

40

60

80

100

120

Exhibit 4-17 Office New Supply and NetAbsorption

■ New Supply Net Absorption

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*20

06*

2007

*


*Forecasts.

5%

10%

15%

20%

25%

Exhibit 4-18 Office Vacancy Rates

CBD Surburban

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*20

06*

2007

*

New

Sup

ply

(msf

)

Net A

bsor

ptio

n (m

sf)


*Forecasts.

AvoidRents may not catch up to support the low cap rates manyinvestors seem willing to pay, especially in markets more proneto competition from new development. Watch out for tenantmusical chairs—moving out of older space into newer buildingsand locking in the lowest possible rents before markets have achance to tighten further. Older space loses.

DevelopmentConstruction material bills shoot up, widening the gap betweenreplacement cost and current market rents. Investors gaingreater confidence that development can be contained to helpsustain the ongoing market convalescence. But cap rate com-pression encourages developers to put some projects back onthe drawing boards. If development gets stoked too soon, officemarkets would backslide given comparatively fragile tenantdemand. Chicago and Philadelphia built through the soft patchand will suffer.

Outlook Office looks risky compared with other traditional core invest-ment categories—apartments, industrial, and retail. “Investorsshould have higher yield expectations” unless they are buyingtrophy office properties in barrier-to-entry 24-hour marketswith good jobs and growth prospects. Then buyers should justback up the Brinks truck at the closing.


comparatively fragile tenant demand.

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Exhibit 4-19 Office Property Total Returns

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*




Exhibit 4-20 Prospects for Downtown Office in 2006


Investment Modestly Good 5.55 7thDevelopment Modestly Poor 4.34 10thSupply/Demand Balance Fair 5.31 9th


Buy Hold Sell22.6% 31.7% 45.7%


Exhibit 4-21 Prospects for Suburban Office in 2006


Investment Fair 5.47 8thDevelopment Fair 4.60 9thSupply/Demand Balance Fair 5.18 11th


Buy Hold Sell20.4% 35.6% 43.9%


RetailStrengthsRetail property performance “cannot get any better.” As long asconsumers keep spending, properties will generate cash flow.“Americans love to shop, we all know that, but how long canthey keep it up?” Investors, meanwhile, “love the income”—that’s good, because appreciation will be hard to come by atcurrent pricing levels. . . . Fortress malls and infill neighborhoodcenters in upscale suburban markets look unassailable. REITscontinue to corner the market on the top-grossing regional cen-ters. Most other capital turns to grocery-anchored retail, wheretransaction activity has been frenzied. Buyers need to focus oncenters with a number-one or number-two supermarket chainto buffer inroads from discount giants. Urban retail, usuallypart of mixed-use projects in prime 24-hour districts, alsoappears sound. Downtown shoppers either walk or take masstransportation—they don’t fret as much over gas station pricesbefore heading to the store.

WeaknessesThe retail sector “must come down to earth.” Rising energycosts; higher local property taxes; interest rate hikes on creditcards, car payments, and mortgages; and increasing medicalexpenses start to impinge on consumer spendthrifts. Gas pumpprices worry retailers the most, not only cutting into shoppingbudgets, but also discouraging extra car trips to malls andpower centers. Unless wage rates accelerate, people will havefewer choices—they must focus more on necessity buying (foodand groceries) than wish-list items (everything else). Federal taxcuts and mortgage refinancings have begun to run their course,and consumer debt levels remain worrisome. “People have bor-rowed money they don’t have to buy what they don’t need.” Forinvestors, “cap rate compression is over . . . period.” Grocery-anchored retail is “priced to absolute perfection. Buyers can nolonger have any appreciation expectations. They’re buying along bond in a rising interest rate environment.”

Best BetsEmerging Trends interviewees send unmistakable sell signals for allretail categories: malls, grocery-anchored retail, and especiallypower centers. After a run of spectacular 20 percent–plus annu-alized returns, retail properties have hit their cyclical highs. Givencapital demand, owners have an excellent opportunity to winnow


The retail sector “must come down to earth.”

0

10

20

30

40

50

0

2

4

6

8

10

12

Exhibit 4-22 Retail Completions andVacancy Rates

■ Completions (msf) Vacancy Rate %

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*20

06*

2007

*

Source: REIS.

Note: For top 50 markets.

*Forecast.

-20%

-10%

0%

10%

20%

30%

40%

50%

Exhibit 4-23 Retail Property Total Returns

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*




Com

plet

ions

(msf

)

Vaca

ncy

Rate

%

portfolios, holding their best infill properties. Buyers beware:“Market pricing is nuts,” says a major mall owner. “It’s more cycli-cal than secular. We’re holding powder dry for the next phase.”

AvoidSteer clear of weaker regional centers and neighborhood centeroutliers. If consumers turn parsimonious, B/C malls with sec-ond-rate anchors and minor league tenant lineups will feel thepinch first. The ghost mall syndrome will be alive and well.Buyers need to discriminate more carefully about anchors, creditrisk, and locations. Wal-Mart and Target remain a threat toregional centers anchored by dog-eared, “mid-price-point

department stores.” The merger between Federated and Mayguarantees anchor closings in some second-tier centers. Powercenters depending on movie multiplexes wobble—Hollywoodflicks look as good on flat screens at home without the stalepopcorn smells. Large discounters make significant inroads intogrocer market shares. Again, shopping centers leasing to C-teamsupermarket chains and drugstores will be extremely vulnerable.Their anchors only can lose to the discounter giants on pricingfor consumer staples. Some chains won’t survive.

DevelopmentSky-high pricing on existing neighborhood retail goads devel-opers into breaking ground—they can build more cheaply thanbuy and sell profitably into the demand curve. “Discipline

slips” in some markets. The trend to consolidation amongretailers, dominated by discounters (Wal-Mart, Target,Marshalls, Kohls) and a few major category killers (HomeDepot, Lowes, Bed Bath & Beyond) may help constrain devel-opment. Builders need one or more of these major tenants tojustify a new large-scale project. Spec neighborhood centerdevelopers need to be careful, too. Smaller regional grocers startdisappearing—they can’t go head to head against Wal-Mart orTarget. The pool of available tenants dissipates.


Exhibit 4-24 Prospects for Neighborhood/CommunityShopping Centers in 2006


Investment Modestly Good 6.01 3rdDevelopment Modestly Good 6.22 1stSupply/Demand Balance Modestly Good 6.38 1st


Buy Hold Sell20.8% 32.2% 47.0%


Exhibit 4-25 Prospects for Power Centers in 2006Prospects Rating Ranking

Investment Modestly Good 5.76 5thDevelopment Modestly Good 5.73 3rdSupply/Demand Balance Modestly Good 6.20 3rd


Buy Hold Sell14.3% 28.2% 57.6%


Exhibit 4-26 Prospects for Regional Malls in 2006Prospects Rating Ranking

Investment Fair 5.45 9thDevelopment Modestly Poor 4.30 11thSupply/Demand Balance Modestly Good 6.18 4th


Buy Hold Sell10.3% 40.0% 49.7%


Shopping centers need to reinvent themselves constantly tostay competitive and meet the needs of retailers’ ever-changingmarketing strategies—whatever lures customers. New powercenters may combine big-box, lifestyle, and Main Street ele-ments, including restaurants, supermarkets, and even depart-ment stores. Malls and neighborhood centers will also addlifestyle components to blunt competitors. Starbucks locatesnext to Safeway. “Expect more high-end merchants and dis-counters at the same property. Owners may attempt to extractadditional “hidden value” on large mall tracts, adding mixed-use components—apartments, hotels, even office.

OutlookTemperamental energy prices hold the key. Sustained highcosts—car fuel, heating, and electricity—could finally breakconsumers’ backs. If oil markets relax and the economy pro-duces more high-paying jobs, shoppers get another life. Themarket for properties will begin to bifurcate as buyers becomemore discriminating, distancing themselves from centers withmore questionable tenant rosters. Development picks up tocatch the tail end of the capital wave. Under any circumstances,retail property performance scales back in an inevitable rever-sion to the mean.

Housing StrengthsLow interest rates have been the bulwark of the nation’s unprece-dented housing boom. As long as mortgage rates stay low andlenders pursue “forgiving” credit standards, buyer demand can besustained among many people who otherwise couldn’t afford steepprice tags. The recent buying binge has been extraordinary—nearly 70 percent of the country now owns homes and multiplehomeownership has increased significantly. “Does everyone havethree houses in America?” Fear of bubbles “is overblown.” Anycorrections should be confined to local areas. “Housing marketsare not centralized like stocks and bonds; supply/demand andpricing are very market-by-market specific.”

WeaknessesHousing values are “too frothy” and “unsustainable.” Middlingwage hikes promise to “put a lid on prices.” “If home pricesincrease by 20 percent a year and incomes rise by less than 5percent, then a disconnect eventually occurs in affordability.” Insome product-constrained areas like southern California and


Home prices will flatten in most areas during 2006–2007, with outright declines in certain overheated markets where speculators have been active.

0 5 10

Supply/Demand BalanceDevelopment

Exhibit 4-27 Prospects for For-Sale Housing in 2006


Infill and Intown Housing

Detached Single-Family(Moderate Income)

Second and Leisure Homes

Attached Single-Family

Detached Single-Family (High Income)

Timeshare Properties

MultifamilyCondominiums

Golf Course Communities

6.99

6.46

6.78

6.39

6.60

6.25

6.60

6.19

6.43

6.02

6.14

5.65

6.09

5.09

5.60

5.35

certain Northeast metropolitan areas, 20 percent or less of thelocal population can afford median home prices. Something hasto give. “Markets have been almost totally finance driven,” andnow mortgage rates edge up. Over 30 percent of recent loansare interest only, and by some estimates speculators purchasedmore than 20 percent of homes in 2004. Floating-rate debtcould become a problem soon when buyers can’t make higherpayments. Surging property values have hiked property assess-ments and tax bills in many areas, adding to carrying costs. A“ton of for-sale signs” begins to appear on lawns in some placesas owners try to cash out at perceived peaks. Recent homeaffordability “has sucked demand forward” and may result inlower future demand. Twenty-something buyers usually mustwait until they accumulate enough wealth. But adjustable-ratemortgages, negative amortization, tiny downpayments, andother financing exotica grease the skids for eager purchasers.“Lenders and borrowers have been stretching to within an inchof their lives to make deals work.”

Best BetsBaby boomer demand for second homes in resort and retireeareas will build, regardless of the interest rate picture. The 50-to 60-year-old cohort wants waterfront locations, chalets withmountain vistas, beach retreats, and championship golf coursevillas. At their peak earning and cash accumulation years, manyboomers can afford to buy even if mortgage rates increase.

Single-family building activity should remain above averagein high-growth regions, primarily in the South and Southwest,where population inexorably shifts. Top states: Florida, Texas,North Carolina, Georgia, Arizona, and California. The GulfCoast will undergo a mammoth resurrection in the wake ofKatrina and Rita.

Infill and urban townhouse, condominium, and coop proj-ects will gain increasing favor from the move-back-in crowd.

AvoidSpeculators need to back off. Buy-and-flip schemes to make for-tunes will fall out of favor like Internet stock picks circa 2000.Tune out those infomercials. Buyers should bypass neighborhoodsand projects where speculators have been active until prices settleor bottom out. Carrying costs and defaults should force productback on the market. Then look out for some bargains.

DevelopmentGreenfield homebuilders hope oil prices nosedive back to rea-sonable levels. Otherwise anticipate newspaper and TV reportsabout nosebleed winter heating bills for all those owners of newexurban McMansions with cathedral ceilings. Insulation andsolar panels make a comeback. High-flying homebuilder stockscould correct as buyer fervor ebbs and construction materialcosts increase. Margins may get squeezed. Everybody takes theirtools to the Gulf Coast.

OutlookMortgage rate movements may not shock most markets, but “aleveling off in appreciation is inevitable.” Prices will flatten inmost areas during 2006–2007, with outright declines in cer-tain overheated markets where speculators have been active.Property values could stagnate for several years. Over time,homeownership will endure as a solid investment for users, butlate-in-game investor-only buyers will fare poorly. The spate oflow mortgage rate–driven homebuying will be over soon.


overheated markets where speculators have been active.

500,000

1,000,000

1,500,000

2,000,000

Exhibit 5-28 Single-Family Housing Starts

Units

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

*20

06*

Sources: U.S. Census Bureau, National Association of Home Builders (NAHB).

*Figures from 2005 and 2006 are NAHB forecasts.

NichesResorts/Resort HotelsSecond homes in resort areas relish a growing market—affluentbaby boomers look toward comfortable retirements and forlegacy properties to pass on to children. Developers shouldinclude home offices in high-end projects. Satellite/cable/high-speed Internet technology enables executives to spend moretime working away from headquarters in their cozy retreats.Hotel owners add condominium units to attract buyers whowant extra services and amenities.

Mixed UseLenders and investors become more comfortable with mixeduse, embracing the need for sophisticated infill developmentthat meets increasing demand from people looking for greaterlifestyle convenience. “It’s more mainstream” and “in vogue.”“Demographics, city planning, commuter preferences favor thetrend” and diversified income streams from a single property canbe attractive. Most projects center around residential compo-nents, office is less crucial. “Small [site] and tall” high-rise resi-dential combined with low-rise retail becomes more common,especially in urbanizing districts. Apartments with supermarkets

“are a strong infill amenity.” Projects near transit stops have thegreatest allure—“street cars, light rail, street grids, and residentialwoven around retail and office.” “Leasing is much stronger inbuildings where you can walk to restaurants or stores.” “Problemsendure in underwriting multiple uses in a single property,” andmany developers lack expertise in delivering all property types.“There always seems to be a dog element.” Urban mixed userequires greater density to pay for infrastructure costs. Sites arestill difficult to assemble and entitle. “Fewer opportunities existthan city planners would like to recognize.”

Public StorageThese rentable warehouse units have investment profiles“resembling multifamily” with short-term leases that canquickly adjust to economic conditions. Storage rents typicallyrun higher than apartments on a square-footage basis, operatingexpenses are far less, and tenant problems are minimal. Thedusty old couch under the drop cloth doesn’t call the super. Butlet’s face it—this is a thin market. Institutional investors havebeen buyers, driving down cap rates, only because traditionalproperty sectors have become too expensive for their fiduciarytastes. Developers often have trouble getting zoning approvals;public storage creates few jobs and little commerce. But other-wise few barriers to entry exist for these easy-to-build facilities.


Lenders and investors become more comfortable with mixed use.

Seniors’ HousingInvestors continue to itch to get into seniors’ housing, figuringthe country’s aging demographics will propel demand. Theymay be right eventually, but the graying baby boomer tidalwave is still probably 15 years away from clamoring for variousforms of assisted care living. Supply tends to track ahead of themarket. “Beware of ramped-up development pipelines.” Activeadult communities are a better bet for now.

Student Housing, Medical OfficeState budget shortfalls force many public universities to rely onprivate developers to meet student housing needs. Old dorms—built to accommodate the baby boom influx in the late 1960s and1970s—need renovation or redevelopment. Echo boom studentsdemand upgrades and many colleges realize they need to retool tostay competitive . . . . Medical office buildings near hospitals canattract steady and reliable tenancy from physicians and their staffs.Increasing numbers of older people translate into more sicknessand care and will require more doctors and hospitals.



IntervieweesThe Ackman-Ziff Real Estate Group, LLCGerald S. CohenPatrick HanlonRussell SchildrautSimon Ziff

Advance Realty GroupGregory N. Senkevich

AEW Capital Management, LPDouglas J. Poutasse

AG Edwards & SonsMichael Bluhm

Alaska Permanent Fund CorporationDavid Stuart

AMB Property CorporationJohn T. MeyerDavid C. Twist

American Realty AdvisorsKirk V. HelgesonBrian K. Wilson

AssurantJay Brinkerhoff

Atlantic Station, LLCBrian Leary

Blackrock RealtyJay AlexanderWilliam A. FinelliFred Lieblich

Blackstone Realty AdvisorsJohn Z. Kukral

BNP Residential Properties Trust, Inc.Philip S. Payne

Broadway Real Estate PartnersBrian Zila

Burnham Real EstateGreg BiscontiStath KarrasD. Mickey MoreraJim MunsonRobert PrendergastThomas W. van BettenJonathan A. Walz

Buzz McCoy Associates, Inc.Bowen H. “Buzz” McCoy

CalPERSAlbert E. GrijalvaMichael B. McCook

CalSTRSJames J. HurleyMichael J. Thompson

CB Richard Ellis InvestorsDouglas HerzbrunWilliam C. Yowell III

Champion PartnersJeff Swope

Charter Properties Inc.Dean R. DeVillers

Childress Klein PropertiesLandon R. Wyatt III

Citigroup Property InvestorsJoseph F. Azrack

Citistates GroupPeter Katz

Colony Capital, LLCRichard B. Saltzman

Column Financial, Inc.Kieran Quinn

Commercial Mortgage AlertPaul Fiorilla

Commercial Mortgage SecuritiesAssociationDorothy Cunningham

The Concord GroupJohn R. Shumway

Continental Development CorporationAlex J. Rose

Cornerstone Real Estate AdvisersMarc Louargand

Crescent Real Estate Equities, Inc.Jeanette Rice

Crescent Resources LLCHenry C. Lomax, Jr.

Crosland Inc.Edward F. LongTodd W. Mansfield

Cushman & Wakefield, Inc.Timothy Welch

Deutsche Bank/RREEFCharles B. Leitner

Dewberry CapitalLara O. Hodgson

East West Partners–Western DivisionHarry H. Frampton III

Ernst & YoungDale Anne Reiss

First Fidelity Mortgage CorporationLance Patterson

Florida State Board of AdministrationDouglas W. Bennett

Forest City EnterprisesJames A. Ratner

Fremont Realty CapitalMatthew J. ReidyClaude J. Zinngrabe, Jr.

GE Commercial Finance Real EstateMichael E. Pralle

General Electric Capital CorporationMichael P. Jordan

Glenborough Realty Trust Inc.Alan Shapiro

GLL PartnersDietmar Georg

GMAC Commercial MortgageThomas MacManus


Morgan StanleyScott BrownKevin MidwinterOwen D. Thomas

National Association of Real EstateInvestment TrustsSteven A. Wechsler

New Plan ExcelGlenn Rufrano

New York State Common Retirement FundMartin S. Levine

PNC Real Estate FinanceWilliam G. Lashbrook

Portman HoldingsBuddy Small

Principal Real Estate InvestorsMichael J. Lara

Property & Portfolio Research, Inc.Susan Hudson-Wilson

Prudential Investment ManagementAlyce B. DeJongGary L. KauffmanYouguo LiangLester F. LockwoodTom McWhirteDale Taysom

Prudential Real Estate InvestorsJ. Allen Smith

Real Capital Analytics, Inc.Robert M. White, Jr.

The Real Estate RoundtableJeffrey D. DeBoer

Realpoint ResearchJames Titus

Regency CentersBrian M. Smith

Related Companies LPStephen M. Ross

GMAC Institutional AdvisorsRobert Fabiszewski

Greencourte Partners, LLCRandal K. Rowe

The Greenwich GroupR. Gary Barth

Grubb & EllisOliver Fleener

GVA Lat Purser & Associates, Inc.Lat W. Purser III

Heitman LLCRichard Kateley

HIGroup, LLCDouglas H. Cameron

Holliday Fenoglio Fowler LPMark D. Gibson

Hyde Street HoldingsPatricia R. Healy

ING Clarion PartnersStephen J. FurnaryStephen B. HansenWill McIntosh

Institutional Real Estate, Inc.Geoffrey Dohrmann

INVESCOBill GrubbsSteve Walker

The Irvine CompanyDavid DeanRick FrommCraig JonesScott A. Lanni

The John Buck CompanyCharles Beaver

John Burns Real Estate ConsultingJohn BurnsTaylor Padgett

Jones Lang LaSalle, Inc.Bruce Ficke

JPMorgan FlemingJoseph K. AzelbyDave EsrigKevin J. FaxonEllie KerrJustin M. MurphyAnne S. PfeifferFrederick N. SheppardJames M. Walsh

Kennedy Associates Real EstateCounsel, Inc.David P. LindahlBrent Palmer

Koll Bren Schreiber Realty AssociatesCharles Schreiber, Jr.

Lachman AssociatesM. Leanne Lachman

LaSalle Investment Management, Inc.William J. MaherLynn Thurber

Lazard Freres Real Estate Investors, LLCRobert C. Larson

Lehman BrothersRobert C. LieberRaymond C. Mikulich

LEM Mezzanine, LLPHerb Miller

Lewis Operating CorporationRandall W. Lewis

MDH Partners, LLCJeffrey P. Small, Jr.

Merrill LynchMartin J. Cicco

MetLifeMatthew T. MabrayJohn D. Menne

Monday Properties LLCMark L. Troen


Retail Property SolutionsDaryl Mangan

Richport PropertiesRick Porter

Robert Charles Lesser & Co., LLCGadi Kaufmann

Rockwood Realty AssociatesMark DeLiloJohn M. O’RourkeJason S. SpicerFrank J. SullivanR. John Wilcox II

Rosen Consulting GroupArthur Margon

Secured Capital Corp.Christopher M. CaseyD. Michael Van Konynenburg

Seven Hills PropertiesLuis A. Belmonte

S.L. Green Realty CorporationMarc Holliday

Sonnenblick-Goldman CompanySteven A. KohnArthur Sonnenblick

State of Michigan Retirement SystemBrian Liikala

State Teachers Retirement System of OhioStanton West

The Staubach CompanyBlair D. Bryan

Tennessee Consolidated Retirement SystemPeter L. Katseff

TIAA-CREFAlice M. Connell

The Townsend GroupFrank Blaschka

Trammell Crow CompanyRusty Tamlyn

Trammell Crow ResidentialJ. Ronald Terwilliger

Transwestern Investment CompanyStephen R. Quazzo

Trinity Real Estate, Inc.Richard Leider

UBS Global Asset ManagementLijian Chen

UBS Realty Investors LLCJim O’Keefe

University of California at BerkeleyKenneth T. Rosen

VEF Advisors, LLCJames Ryan

Vestar Development Co.Lee T. Hanley

Vornado Realty TrustMichael D. Fascitelli

Wachovia Bank, NAMark MidkiffGregg Strader

Watson Land CompanyBruce A. Choate

Wells FargoA. Larry Chapman

Wells Real Estate FundsDon MillerDavid Steinwedell

Westfield Capital PartnersRay D’Ardenne

Westfield Corporation, Inc.Peter F. Koenig

The Winter Group of Companies, Inc.Robert L. Silverman


Joseph AzrackCitigroup Property InvestorsNew York, New York

John C. Cushman III Cushman & Wakefield, Inc.Los Angeles, California

Mark EppliMarquette University College of

Business AdministrationMilwaukee, Wisconsin

Stephen J. Furnary ING Clarion PartnersNew York, New York

David GeltnerMIT Center for Real EstateDepartment of Urban Studies

and Planning Massachusetts Institute of TechnologyCambridge, Massachusetts

Jacques GordonLaSalle Investment ManagementChicago, Illinois

Joseph GyourkoThe Wharton Real Estate Center University of PennsylvaniaPhiladelphia, Pennsylvania

Susan Hudson-WilsonProperty & Portfolio ResearchBoston, Massachusetts

Mike MilesGuggenheim Real EstateWinchester, Massachusetts

James O’KeefeUBS Realty Investors, LLCHartford, Connecticut

Ken RosenFisher Center for Real Estate

and Urban Economics Haas School of BusinessUniversity of California at BerkeleyBerkeley, California

Richard B. Saltzman Colony Capital, LLCNew York, New York

C.F. SirmansUniversity of ConnecticutStorrs-Mansfield, Connecticut

James R. WebbJames J. Nance College of BusinessCleveland State UniversityCleveland, Ohio

Advisory Board for 2006


PricewaterhouseCoopers real estate group assists real estate investmentadvisers, REITs, public and private real estate investors, corporations,and real estate management funds in developing real estate strategies;evaluating acquisitions and dispositions; and appraising and valuingreal estate. Its global network of dedicated real estate professionalsenables it to assemble for its clients the most qualified and appropriateteam of specialists in the areas of capital markets, systems analysis andimplementation, research, accounting, and tax.

Real Estate Leadership TeamPatrick R. LeardoGlobal Real Estate Business Advisory ServicesNew York, New York646-471-2666

Robert K. Ruggles IIIReal Estate Valuation Advisory ServicesNew York, New York201-689-3101

Peter F. KorpaczReal Estate Business Advisory ServicesBaltimore, Maryland301-829-3770

www.pwc.com

Sponsoring OrganizationsULI–the Urban Land Institute is a nonprofit research and educationorganization that is supported by its members. Its mission is to provideresponsible leadership in the use of land in order to enhance the totalenvironment.

The Institute maintains a membership representing a broad spec-trum of interests and sponsors a wide variety of educational programsand forums to encourage an open exchange of ideas and sharing ofexperience. ULI initiates research that anticipates emerging land use trends and issues and proposes creative solutions based on thisresearch; provides advisory services; and publishes a wide variety ofmaterials to disseminate information on land use and development.

Established in 1936, the Institute today has more than 27,000members and associates from some 80 countries, representing the entire spectrum of the land use and development disciplines.Professionals represented include developers, builders, property own-ers, investors, architects, public officials, planners, real estate brokers,appraisers, attorneys, engineers, financiers, academics, students, andlibrarians. ULI relies heavily on the experience of its members. It isthrough member involvement and information resources that ULIhas been able to set standards of excellence in development practice.The Institute is recognized internationally as one of America’s mostrespected and widely quoted sources of objective information onurban planning, growth, and development.

Senior ExecutivesRichard M. RosanPresident

Cheryl CumminsChief Operating Officer

Rachelle L. LevittExecutive Vice President, Policy and Practice

ULI–the Urban Land Institute1025 Thomas Jefferson Street, N.W.Suite 500 WestWashington, D.C. 20007202-624-7000www.uli.org


Emerging Trends in Real Estate® 2006What are the best bets for development in 2006? Based onpersonal interviews and surveys from more than 400 of themost influential leaders in the real estate industry, this forecastwill give you the heads-up on where to invest, what to develop,which markets are hot, and how the economy, social andpolitical issues, and trends in capital flows will affect real estate.A joint undertaking of PricewaterhouseCoopers and the UrbanLand Institute, this 27th edition of Emerging Trends is theforecast you can count on for no-nonsense, expert advice.

Highlights

■ Tells you what to expect and where the best opportunities are.

■ Describes trends in the capital markets, including sources andflows of equity and debt.

■ Advises you on those metropolitan areas that offer the mostpotential.

■ Tells you which property sectors offer opportunities and whichones you should avoid.

■ Provides rankings and assessments of a variety of specialtyproperty types.

■ Reports on how the economy and concerns about job growthare affecting real estate.

■ Describes the impact of social and political trends for real estate.

■ Explains how locational preferences are changing.


www.pwc.comwww.uli.org

ULI Order Number: E23

ISBN: 978-0-87420-948-8

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