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Because closed-end funds can be hard to bring to market, fund companies tend to start new ones in those market areas where individuals are most eager to invest. That often means that these sectors are overvalued in comparison with the rest of the market. [Increased internet funds in the late 90s and foreign funds in the 80s are examples of closed-end funds bad timing.] Recently, real estate has been the focus of many new closed-end equity funds. During the 1990's, only one such fund was issued - in 1993, raising just over $100 million. But two started in 2001, and six more in 2002, raising a total of more than $2.1 billion. Because of that popularity, investors may want to bet that real estate will lag behind the rest of the stock market over the next decade.
In Q1-03, Houston issued permits for 5,200 units. Las Vegas was second with 2,500 apartment units permitted, according to M/PF Research, leaving Houston well ahead of the pack. As many as 20,000 new units will be completed in 2003, several times the 5,600 units built in 2002, said Richard Zigler, director of research for O'Connor & Associates. According to Apartment Data Services, 48 apartment complexes with 12,615 units are under construction in the area. The overall Houston apartment market has 455,000 units in 2,386 complexes. The areawide occupancy rate in June was 89.5%, down from 91.9% in June 2002, according to Apartment Data Services. The typical apartment in the Houston area is renting for $611 per month, down slightly from $612 in June 2002. Since 1990, the areawide occupancy rate has been ranging from 88% to 91%. Sixty-one percent of Houston-area apartment owners were offering free rent or similar incentives, such as waiving the initial deposit. A year ago, only 37% of local landlords offered incentives, according to Apartment Data Services, a Houston firm that tracks the nuances of the apartment business. The apartment market's health is tied to job growth and the economy. Houston has lost 15,000 jobs over the last 12 months.
But bears worry that general investors are rushing in at just the wrong time. Rents are still falling in some markets, and vacancies - averaging 17% in office buildings nationally - are high by any historic measure. The group trades at an average of 14.4 times a commonly used earnings measure known as funds from operations, well above the 10-year average of 11.8 times, according to Green Street Advisors. REIT stocks now trade at an average of 105% to 115% of the estimated value of their assets in the private market. REITs historically have traded at about 100% of net asset values. What's more, good news for the economy could be bad for REITs. Other stocks would become more attractive, while REIT earnings, which lag behind the broader economy, are expected to be still-mired in bad property markets. Yield chasers would flee as pressure builds on long-term interest rates. Bears also note that REIT insiders are sellers - by a 24-to-1 ratio in the first quarter, according to Lehman, which tracks transactions over 10,000 shares. Bulls do have a case. Mike Kirby, a Green Street analyst, notes that continued low interest rates, combined with a sluggish economy going forward, would make REITs still look good relative to other investments. The benchmark 10-year Treasury note - the usual comparison because REIT leases average about 10 years - trades at a yield of 3.32%. Also, pension funds and other institutional investors have been on a property-buying binge, paying up for property cash flows. Their purchases have pushed down initial yields on buildings and increased the value of property that REITs have on their books. Merrill Lynch's Steve Sakwa, another REIT analyst, sees it this way: "All investments have lower return expectations. Why shouldn't real estate?"
Apartment developers will complete more than 208,000 units this year in 60 major U.S. markets, 1.4% more than last year, Torto Wheaton Research estimates. Employment last year fell 0.9% and will increase 0.4% this year, according to RBC Capital Markets. A slower-growing economy will delay the apartment industry's recovery to the second quarter of next year from the fourth quarter of this year, RBC said. Earnings for apartment REITs fell 14% in Q1-03, the weakest performance of all REIT property types, according to Smith Barney. Earnings for 2003 will slide 11%, Smith Barney predicts. AvalonBay's Q1 earnings declined 17%, to $57.5 million, from the year-earlier quarter. Equity Residential's earnings slid 12%, to $168.6 million. The national homeownership rate has risen almost 4 percentage points, to 68%, since 1993, according to the U.S. Census Bureau. Homeownership may climb to 70 percent in the next five years, said Douglas Duncan, an economist at the Mortgage Bankers Association of America. Landlords are reducing rents or offering one month or more free to draw renters. Equity Residential increased spending on such concessions by $3.7 million, or 42%, in the first quarter from the year before. Concessions were offered in about 33% of apartment markets at the end of last year, up from 28% of markets a year earlier, according to RBC.
But these conditions have not deterred two major Chicago developers [the Pritzker family and Higgins Development Partners, and the John Buck Company] from starting two high-profile office buildings [Hyatt Center and 111 South Wacker] totaling more than 2.8 million square feet of space. Hines Interests of Houston, has announced a tentative starting date later this year for a third high-rise. The owners of these buildings in progress plan to entice existing downtown companies to leave their current space with promises of being in new, technologically up-to-date buildings on one of Chicago's premier business streets. Wacker Drive [the location of both Hyatt Center and 111 South Wacker] is also home of the Sears Tower. Mr. O'Donnell of the John Buck Company, the developer of 111 South Wacker, said, "We're 42.5% leased and are currently talking to three other tenants that will take it to 75%." Hyatt Center's anchor tenants are the Pritzker-owned Hyatt Corporation; Goldman Sachs; and the law firm of Mayer, Brown, Rowe & Maw. The three will occupy two-thirds of the building's 1.8 million square feet. Both developers say they are asking for, and receiving, rents in the mid to upper $20's. "Somewhere between 50 and 60 percent leased is where you need to get to start building," said Greg Van Schaack, vice president of Hines Interests. "We're close." Interest rates remain low enough that developers are currently able to carry buildings with significant vacancy levels for longer periods of time. Chicago Update After suffering through the highest vacancy rates in 10 years in 2002, the Chicago office market is expected to get worse, according to a study from Jones Lang LaSalle. Office vacancies are predicted to top 15% by the end of the year and could approach 15.5% by 2005 - the highest ever. At this point, Class A rents average about $19.89 per square foot on a net basis. Class B rents are $14.33 per square foot. The average for Class C rents are expected to hold steady at $9.37 per square foot. Suburban office markets will also experience a drop in rent of around 2-4%. Class A and B suburban office rents are $17.44 per square foot and $14.77 per square foot, respectively. (Institutional Investor 6-5) Chicago Update (& Diverse Economies) The City of Broad Shoulders may be staggering a bit from an office vacancy rate that Insignia/ESG Inc. put at 18.2% at the end of the first quarter, but there's new evidence that Chicago should rebound strongly once the economic recovery takes hold. Moody's Investors Service recently cited Chicago as having the most diverse economy in the nation--a distinction it earned based on how closely the city's economy matches the various components that make up the national economy. With a mix of Old and New Economy industries, Chicago is in the best position to take advantage of job growth in whatever sector it may occur. Other cities rounding out the Top 10 in Moody's economic diversity study (which the rating agency uses in analyzing the CMBS market) are Little Rock; Baltimore; Salt Lake City; Buffalo, N.Y.; Nassau-Suffolk counties in New York; Columbus, Ohio; Nashville; Atlanta; Portland, Ore.; and Oakland, Calif. (Jessica Roe, CPN 6-17)
George Strachan, an analyst with Goldman Sachs, predicted in a recent report that discounters would grab more than one-third of the 800 anchor locations that are expected to become vacant over the next decade. Wal-Mart is replacing J.C. Penney as an anchor in the Sunrise Mall in Nassau County, and will be a new addition at the Westfield Shoppingtown Parkway in El Cajon, Calif. The majority of Wal-Mart's 2,845 U.S. stores are still in strip centers; the retail giant currently operates just four mall stores. Richard Green, vice chairman of mall developer Westfield Corp., said he recently signed five deals with Target, for leases in San Diego, Calif.; Los Angeles (home to two sites); Enfield, Conn.; and Wheaton, Md. "A developer would typically have to write a check of $1 million to $5 million just for the privilege of having a chi-chi department store in the mall," said Joseph J. Sitt, chairman and CEO of Thor Equities, which manages retail properties nationwide. "Am I offering those types of incentives to discounters? No. And that's making it sexier to work with them." Operating covenants governing shopping malls traditionally contained a clause that prevented landlords from leasing to discount stores - a provision tenants demanded to guarantee a mall's upscale image. But today, as department stores lose out to discounters in the battle for consumer dollars, they wield less clout with landlords.
Pilarz focused his attention on White Mountain Mall in Rock Springs, Wyo., which had an empty anchor space. The space, which was formerly occupied by Wal-Mart, was vacant for four years before Pilarz came up with the idea of putting a Harley-Davidson dealership in the mall. When Pilarz approached David and Lynda Laughlin, the owners of the Flaming Gorge Harley-Davidson, they were excited about the opportunity. "Most alternative anchors have the impression that it's too expensive to do business in a mall because of the operating cost and rent, but we offer rates that are comparable to what they are already paying," Pilarz said. The Flaming Gorge Harley-Davidson opened two months ago in a 45,000-square-foot space. As the first mall dealership, a lot of time was spent on designing the space. The new store boasts a 27,000-square foot retail center that includes Harley clothing and accessories. The remaining square footage houses the bike showroom as well as a state-of-the art service center. Pilarz believes that other Harley-Davidson dealership owners will now consider being in a regional mall. "I think this is the future for Harley-Davidson, but also the future for mall owners," he noted. "Malls have to be all things to all people, and we have to try to create different reasons for people to visit frequently." To that end, Pilarz is looking into home improvement retailers and grocery stores to take over empty anchor space.
Take someone who buys a commercial property for $100,000 and holds on to it for 10 years. When depreciated on a 39-year schedule, the property's tax basis is about $75,000. If the owner sells the property for $110,000, that would represent a $35,000 gain. But only $10,000 of that gain would be taxed at the lower 15% capital-gains rate. The other $25,000, which represents the depreciation over 10 years, would still be taxed at the 25% rate. Industry leaders argue that the 25% recapture tax rate puts real estate at a disadvantage relative to other investment sectors. History of Rate Changes 1981: Depreciation period is set at 15 years, without regard to the building's so-called useful life. Nonresidential real estate was subject to full recapture at ordinary-income tax rates. 1984 and 1985: Depreciation increased to 18 years for nonresidential and 19 years for residential property. 1986: Congress repealed the special rules for capital gains, so ordinary income was taxed at the same rate as a capital gain. Also, the recovery period was increased to 27.5 years for residential and 31.5 years for commercial buildings. 1990: The individual ordinary-income tax rate was increased to 31%, with the maximum capital-gains tax rate set at 28%. 1993: The Revenue Reconciliation Act of 1993 increased the top ordinary-income rate to 36% (plus a 3.6% surtax), and left the capital-gains tax rate at 28%. The depreciation period for commercial buildings was increased to 39 years. Depreciation for residential rental property stayed at 27.5 years. 1997: The Taxpayer Relief Act reduced the capital-gains tax rate to 20%, but added a 25% recapture rate for real estate. 2003: The Jobs and Growth Tax Relief Reconciliation Act reduced the capital-gains tax rate to 15% from 20%. Recapture tax rate remains at 25%.
Though total acquisitions of U.S. office properties so far this year fell to $6.49 billion from $8.76 billion for the first half last year, investment activity among foreign investors has declined even more. During Q2-02, foreign investors accounted for 36.4% of total office real-estate-investment activity, Granite Partners said. For Q2-03, foreign investors so far have accounted for 12.2%. Thomas McWhirter, who oversees Prudential Real Estate Investors' TMW Funds Management, which invests on behalf of German investors, said the TMW group typically invests about $750 million a year in U.S. real estate. This year, TMW expects to invest half that and, for the first time in its 20-year history, is looking at investing in Asia. "Yields look particularly attractive there," Mr. McWhirter said.
The Big Apple naturally has a lot of shadow space because it has the largest number of tenants and buildings. But it's also the most burdened because it's the financial capital of the world, and financial services firms have a lot of excess space that they don't want to bring to market right now. Tenants are holding vacant space because: sublease rents are low, they are trying to manage the extra space because they are unsure of future needs, and they don't want to recognize the accounting writedown. And with New York City tenants paying the highest rents in the country, writedowns in this market hurt more.
Davis: We continue to focus on those companies that not only know how to write leases, but also understand how to create value in real estate by selling, by building, or by buying. We call this "working the entire real estate investment cycle." It's not about just being a collector of rent, but about using real estate as a product and deriving the best possible return on that product. Spears: We focus on companies that can manage the entire real estate investment cycle. For example, CenterPoint Properties (CNT) is a company we most often describe as emblematic of a full cycle investor in real estate. CenterPoint targets its investment strategies toward value creation. This can place CenterPoint in the role of acquirer, developer, landlord (i.e., rent collector) or seller. CenterPoint is an expert in each of these functions and, more importantly, knows when each one will add the most value. Historically, investing in real estate was about becoming a bigger company, not a more profitable one. Real estate's greatest potential to add value is through the proceeds an owner earns in the sale of an asset. CenterPoint sells 10%-20% of its portfolio per year and these proceeds become its cheapest form of capital, which the company uses to begin anew the real estate investment process. Davis: The success of a real estate entrepreneur used to be defined more by the amount of square footage of buildings that he or she owned. Now, however, the case success for a real estate entrepreneur is defined by profits that are returned to investors in the form of dividends or plowed back into the company to continue to grow it. That is a very different model from the one that was practiced only 10 or 15 years ago, and that is one of the most basic reasons why [we] are interested in real estate as a product. The rules of success have changed, and they have changed very much in investors' favor. What They Like Spears: CPG is the dominant player in outlet center retail format. It owns three quarters of the assets of the 20 best performing outlet centers in the US, making it the dominant player. Davis: DDR is a strip center REIT whose primary tenants are dominant big box retailers such as Wal-Mart, Target, T.J. Maxx and Lowe's. We continue to see a growing percentage of retail sales accruing to the big box retailers at the expense of traditional department stores.
The vacancy rate ended the quarter at 17.6%, up from 17.4% in Q4-02. The 20 basis-point increase is far lower than the 106 basis-point gain that was the quarterly average in 2001 and 2002. The average vacancy rate for the nation's central business districts remained nearly level at 14.6%, while suburban vacancy rose to 19.3%. Looking at just Class A space, CBD vacancy fell from 13.4% to 13.2%, but suburban vacancy ended the quarter at 20.7%. Net absorption was negative, but just barely, totaling -654,000 square feet compared to the quarterly average of -13.8 million square feet in 2001 and 2002. Class A absorption was a positive 3.7 million square feet, the strongest performance since 2000-Q4 before the economy slipped into recession. Absorption in Class B and C space totaled -4.3 million square feet, which is consistent with anecdotal evidence that tenants in Class B and C properties are upgrading to Class A properties as their leases expire, snapping up bargain rents. The average asking rent for Class A space ended Q1 at $28.50 per square foot. Over the past three years, Class A and B asking rents have fallen by 19% and 17% respectively. The migration of tenants from Class B and C space into bargain-priced Class A space is a natural part of the real estate cycle that presages an overall recovery. Two more leading indicators showed positive movement during Q1: The amount of space remaining in the construction pipeline dropped to 41 million square feet from 51 million at the beginning of the quarter, and sub-lease space fell slightly to 136 million square feet from 140 million. Office property sales exceeded $7.8 billion in 2003-Q1 according to data provided by Real Capital Analytics, up from $6.5 billion in 2002-Q1. The average cap rate rose slightly from 9.0% in 2002-Q4 to 9.2% in 2003-Q1. Boston Update After plummeting close to 50% since the 1990s boom went bust, downtown office rates appear to have stabilized in the $37-to $58-a-square-foot range, reports Cresa Partners, a Hub corporate real estate firm. And vacancy rates, after skyrocketing from the low single digits, have stablized at about 16% in downtown Boston, Cresa reports. That number doesn't take into account another 10-15% of the market that is vacant, but not officially advertised. `It's safe to say that the recession has ended and the corporate real estate recovery has begun, but it will probably be painstakingly slow,' said Joe Sciolla, managing director of Cresa Partners. (Scott Van Voorhis, Boston Herald 6-12) Baltimore Update More than 17% of the space in Baltimore's downtown top Class A buildings is for rent, according to real estate information company CoStar Group, and overall 14.3% of downtown's 17.5 million square feet of office space is on the market. Developers are proceeding with two major projects with Pratt Street addresses that will add 440,000 square feet. (Meredith Cohn, Baltimore Sun 6-12) Dallas Update The overall office vacancy rate in downtown Dallas is just over 30%, compared to more than 35% in office districts in Far North Dallas and in Richardson's Telecom Corridor. Citywide office vacancy as of early June was about 27%. (Steve Brown, Dallas Morning News 6-25) NYC Update Manhattan vacancy rates for commercial space drop to 13.1% last month from 14.6% in May 2002, while midtown vacancies jumped to 12.3% from 10.6% over the same period, according to Colliers ABR Inc., a New York real-estate services firm. And many midtown firms that a few years ago wouldn't have considered moving to the area are doing so, says Howard Fiddle, an executive managing director with Insignia/ESG, the largest New York commercial broker. (Ryan Chittum, WSJ 6-25)
First quarter availabilities (the percentage of total inventory available - both vacant and occupied) again moved higher registering 10.5%, up 40 basis points from Q4 2002. The Q1 availability rate now stands 400 basis points higher than that recorded at the end of 2000. Despite weakening fundamentals industrial rents registered little movement during the quarter. Warehouse rents fell just 0.5% to average $4.60 per square foot while bulk and flex space rents held steady averaging $4.00 and $7.70 per square foot respectively. R&D rents, however, fell moving 0.8% lower to $9.50 per square foot. These gradual declines were similar to those recorded in the 3rd and 4th quarter, in contrast to the office market where rents have dropped precipitously. With the economy languishing and the absence of job creation, the only active segment of the industrial market remains the owner user market. Supported by a good supply of cheap debt, many small and medium sized businesses are abandoning the leasing market and instead choosing to go the owner-occupier route. This trend towards ownership is expected to continue for the balance of 2003 benefited by a 45 year low in interest rates, which in some case leaves owning less expensive than leasing. This combined with consolidation in many industries is producing a very quiet leasing market. Various metrics used to measure the economy show a mixed business environment but until corporate America feels more confident about the future, it is unlikely significant expansion will occur. Many economists are anticipating a strong second half but for industrial real estate owners and developers it may be too little too late to see any benefit in 2003. With the exception of the build-to-suit market, which is also benefiting from record lower interest rates, most industrial markets across the nation look set to be relatively inactive for the balance of the year. Industrial Rebound Amy Choi, CPN 6-05 Assuming a jobless economic recovery, industrial property may be the only real estate sector to recover in the near future. And industrial players have to be ready for it. "Industrial real estate grows with business spending and manufacturing," noted Bill Travers, director of REITs at Fitch Ratings. "You don't need job production for growth in warehouse and distribution, for example. For office or multi-family, you need job formation for them to rebound." In looking at the stock markets, said Travers, one could say that the economy is in the midst of a modest recovery or at least a leveling off of the deterioration. If with the president's stimulus package, recovery comes as soon as early 2004, it's time for industrial developers to get cracking on preparing space to meet increased demand and be proactive in finding tenants for markets that are currently quiet.
Lloyd Linford, the chief executive of Reis, scoffs at claims that the commercial-property market has been tamed. It is true, he says, that there was less speculative development than usual during the recent boom, but the decline in new developments as demand from occupiers collapsed has also been smaller than usual. In previous downturns, developers were forced to halt projects as finance dried up. Today large amounts of capital continue to flow into real estate, allowing construction to be sustained at higher levels. That may mean it will take longer to clear excess supply, and office vacancy rates will stay high for longer, pushing rents even lower. How long before investors and developers realise that the laws of supply and demand have not been scrapped?
The average capitalization rate for office buildings was 9.1% in the first quarter of this year, down from 9.3% a year earlier, Reis says. Other methods of tracking property values also show a drop. Green Street Advisors tracks the private-market value of the assets of certain real-estate investment trusts. Green Street's index of REIT asset values in all property types - office, apartments, retail and industrial - dropped 10.1% from mid-2002 through the first quarter, falling to levels of about three years ago. The drop came after a sharp uptick in values in the first half of 2002, driven by the interest-rate declines.
The firm cautions investors and owners of commercial real estate to expect yields on their investments to continue to fall because of what it calls "cap-ex leakage." Cap ex is shorthand for capital expenditures, the money landlords spend on building improvements, concessions such as free rent and special needs for tenants. Those rising costs are nibbling away at landlords' income and, ultimately, total returns, which are the yield plus the property's appreciation. "Cash flow from [commercial] real estate may have further to fall for investors because leasing costs and concessions will need to rise if landlords want to maintain high occupancies," says Jacques Gordon, international director, investment strategy at LaSalle. Retail buildings had the highest cap-ex leakage of all commercial property in the first quarter, says Mr. Gordon. Taking that leakage into account lowered the sector's yield by 2.3 percentage points to 6.42% for the 12 months ended March 31, according to LaSalle, from the 8.72% yield reported by the National Council of Real Estate Investment Fiduciaries. NCREIF is a Chicago-based association of institutional real-estate professionals with a database that tracks $124 billion of commercial real estate. For the year ahead, Mr. Gordon says LaSalle believes cap-ex leakage will be highest in the office sector, surpassing retail, because of the sorry state of the economy, which has led to larger amounts of vacant space due to lack of demand. LaSalle says cap-ex leakage in office buildings took 2.05 percentage points off the sector's 12-month yield, shrinking it to 6.63% from a reported 8.68%.
Saint Joe - Winer sees the company unlocking hidden value in the millions of acres of land in northwest Florida, which is being developed for residential resorts, single-family homes, as well as condominiums and malls, offices and industrial space. ForestCity Enterprises - A commercial real estate operating company that develops projects in urban areas, ForestCity Enterprises is developing an infill area in New York City and is redeveloping the old Denver airport. Tejon Ranch Co - This company owns 270,000 acres of land 60 miles north of Los Angeles in Kerin County, Calif. Much of the land is adjacent to Interstate 5, the nation's busiest freeway. It is considered the next frontier in California land development. Quick Facts, Stats & Opinions In 2002, $43.5 billion in retail sales occurred over the Internet, up about 26% from 2001, according to CB Richard Ellis Investors, the LA-based real-estate investment-management unit of CB Richard Ellis. Internet sales accounted for 1.3% of total retail sales (excluding food service) in 2002, up from 1.1% in 2001. Assuming that Internet sales increase by $10 billion per year through 2007, they would account for 2.3% of total retail sales by 2007, Ms. Dorrel estimates. Given that, Internet sales could hamper sales at shopping centers, enough to reduce the average shopping center valuation in 2007 by about $10 per square foot on average. (Sheila Muto, WSJ 6-12 ) Jay Habermann has taken over coverage of real estate investment trusts at CSFB and immediately downgraded about one-third of the 22 REITs the bank covers. Habermann is bullish on retail and healthcare REITs and is telling clients to focus on these sectors and underweight sectors including office and multifamily. Still, Habermann names BXP as one of his top picks, along with HCP and GGP. Habermann is looking for a total return of 4-7% in 2003, in line with the broader equity markets. (Tova Gerson, Institutional Investor 6-11) In 1950 there were more than 650,000 suburbanites per existing shopping center, but by 2000, that ratio had drastically declined to just over 4,000 suburbanites per shopping center. Opening a storefront and just "being there" is no longer a sufficient criterion for success in retailing. (Peter Linneman & Deborah Moy, Wharton Real Estate Review Spring 03) After three years of declining growth in retail sales and with no sign of a strong rebound in the U.S. economy, mall developers have pulled in their horns. The pipeline of projects larger than 800,000 square feet has dropped significantly, with the new supply of large centers in 2002 expected to total only 8 million square feet, compared to the 1978-2001 average of 28 million square feet per year. GGP stands out as the boldest groundbreaker with almost 5 million square feet planned to open next year. (Retail Traffic 6-1) Nationally, average office rents have fallen by 18% from their peak, but in San Francisco, Boston and New York the decline has been 60%, 30% and over 20% respectively. Effective rents have fallen by even more, because landlords are offering generous concessions. Silicon Valley a few years ago had some of the world's most expensive offices, but the bursting of the tech bubble has taken a heavy toll. One-third of buildings now stand empty. (The Economist 5-31) A flawed reason often cited for investing in property is that bricks and mortar are more solid than a paper asset. A firm can go bust and disappear, but a building will remain standing. Yet bricks and mortar have no intrinsic value: a shopping mall at the South Pole is worth nothing. Value lies in the rents that a property can generate, not its physical attributes. Without a tenant, income and hence value disappear. (The Economist 5-31) Note: ICF may have had dividends on 6-25, but the amex site I use to verify dividends and check there size does not show this to have happened. So the gains above that index may be exaggerated by 1.5%. RWR is scheduled to dividend on 7-2.
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