By Steve Bergsman

REITs have outperformed over the past 20 years, but will broader market, demographic and economic factors allow those results to hold over the next two decades?

Ten years ago, the country's real estate markets were slowly pulling out of a serious recession. Entering 2003, the real estate markets are again in a downturn and in 2013, we could be in another. There is a cyclical nature and long-term strategy with investing in real estate stocks that investors can lose sight of when company performance dips over a short-term period.

So, while it's hard to see the good tomorrow when an office building has a 33 percent vacancy rate, investors must remember that property markets do turn—not necessarily rapidly, but steadily. Ostensibly that should mean good things for publicly traded real estate companies and their shareholders over the next five, 10 and 20 years as many pundits foresee micro and macroeconomic factors that are favorable to the REIT industry.

"Long-term fundamentals are good," says Glenn Mueller, a professor at Johns Hopkins University and real estate investment strategist at Legg Mason Wood Walker Inc. "The U.S. economy is going to grow, an expanding population will need more real estate and therefore real estate values are going to go up. Over the long-term, REIT stock prices will reflect that trend and move up as well."

Population Growth Favors REITs

Like many industries, demographic factors are one of the most important predictors of future performance—and fortunately for REIT investors, demographics appear to be in the industry's favor. "All the demographic factors are extraordinarily favorable. We are the only industrial country with a growing population—and that will continue," says Jim Smith, chief economist for the Society of Industrial and Office Realtors. "We are one of the richest countries in the world, and we should keep getting richer. Growth increases demand for all sorts of things, including increased demand for hotels, restaurants, shopping centers, industrial warehouses, etc."

Smith says he expects 2004 to be a very good year for commercial real estate, followed by seven or eight years of strong performance before the next recession.

Leanne Lachman, principal and managing director of New York-based Lend Lease Real Estate Investments, says U.S. population growth will continue—although at a reduced rate. In this decade, Lachman predicts population growth will be about 0.9 percent per year. While that is down from 1.3 percent in the 1990s, it is still the equivalent of adding a new Denver metropolitan region or the entire state of Utah every year.

Lachman's 0.9 percent growth presumes there is ongoing immigration—a critical assumption given that immigration has dropped by 30 percent since the Sept. 11, 2001 terrorist attacks. "We cannot afford to have that continue," Lachman says. "We really count on the new immigrants who come at a working age and go straight into the labor force."

The Echo Boom Factor

A key demographic factor in driving growth in many real estate sectors through the next decade will be the rise of the echo boomers—the generation born between 1965 and 1981 who are entering the workforce and helping shape demand for apartments, office space and retail shops. These children of the baby boomer generation are maturing, entering the workforce in greater numbers and moving out on their own, Lachman says.

"While the oldest echo boomers are in their late 30s, most are in their early 20s, and in terms of sheer numbers they are almost as large a group—at 60 million—as the baby boom generation," Lachman says. "If you think back at how much influence the baby boomers had on all kinds of trends in the U.S., certainly on consumer expenditures, it is very cheery to look forward as their kids come into adulthood."

The echo boom impact on retail and multifamily companies already is underway, but the industrial sector also is expected to see a surge from this technology savvy generation. "The echo boomers should lead a tech comeback and create a demand for certain types of industrial space such as flex and R&D," says Ken Riggs, managing partner and chief executive officer of Chicago-based Real Estate Research Corporation (RERC).

In addition to the echo boomers, there also are significant demographic changes occurring at the older end of the U.S. population profile that will impact the real estate market in the mid and long term.

The withdrawal from the marketplace by 83 million baby boomers and 24 million pre-retirees during the next decade and beyond will dramatically affect the economy overall and ripple throughout society, observes RERC's Riggs. "When they stop earning the kinds of peak salaries they are generating now, their spending on the kinds of family related purchases that drive our economy will slow considerably," Riggs says.

In addition, as baby boomers begin to retire in the next five years there will be a noticeable relocation from the Northeast to the retirement-friendly locales of the South and West. "That population shift slowed in the last decade, but with the (baby) boomers approaching retirement it will accelerate again beginning mid-decade," says Mark Zandi, chief economist for economy.com. "Many of the baby boomers will become renters in those markets."

Baby boomers also are expected to bolster the long-term performance of the healthcare sector, says Jerry Doctrow, a managing director with Legg Mason Wood Walker. In addition, the current group of seniors who are older than 75 (the average entry age for assisted-living facilities is in the early 80s) is growing two to three times faster than the U.S. population as a whole, Doctrow says.

Capital Markets Impact Pricing

Two of the biggest influences on real estate are pricing relative to other asset classes and access to capital markets, observes Rick Brace, director of equity research and advisory services at Torto Wheaton. Expansion in the property markets can't happen without a favorable capital market, but sometimes, as in the mid- to late-1990s, there is a disconnect.

According to Brace, property markets in the mid- to late-1990s were improving with vacancies declining and rent rolls moving up, but REITs experienced some of their poorest performances ever. A similar thing happened in 2002, but in reverse. "REIT stocks are not getting crushed but are doing relatively well compared to other stock sectors, whereas real estate fundamentals are actually tailing off at a rapid pace."

What happens to REITs over the next five, 10 or 20 years, says Brace, depends on the capital markets. "It is a question of when do the capital markets realize that the driving of the pricing structure is going to go back to the fundamentals," Brace says.

Along those same lines, a second capital markets factor that will weigh heavily on the performance of REITs is interest rates. "If we continue to have very low interest rates, even into an inflationary environment, REIT returns will continue to remain relatively positive," Brace says. "However, in the next couple of years, we think interest rates are going to rise, and REITs will face a more challenging environment, as will real estate as a whole."

Ken Rosen, chief executive officer of Lend Lease Rosen Real Estate Securities LLC, believes the REIT market will take a positive turn going forward. "The REIT market has done quite well in 2002 when looking at the capital markets. We've had several IPOs and quite a few secondary offerings," Rosen said during a panel discussion at the 2002 NAREIT Annual Convention. "My prediction going forward is that you're going to see a substantial REIT rally despite the weakness in fundamentals."

Legg Mason's Mueller says an increase in interest rates is inevitable and when it happens, multifamily REITs will be the benefactors. "Normally people do not leave apartments in a slow economic period, but interest rates are low and people are buying homes," Mueller says. "Once interest rates move up, apartments will rebound fairly quickly. Long term, apartments will be back in a growth phase."

Composite Real Estate Trend Forecast for Top U.S. Markets Forecast periods for year-end 2002, 2006 & 2011
	Supply Growth				Demand Growth				Vacancy Rate**
	1-year	5-year	10-year		1-year	5-year	10-year		1-year	5-year	10-year
Apartment	1.5%	1.3%	1.3%		0.1%	1.1%	1.3%		6.1%	6.1%	5.0%
Industrial	0.9%	0.8%	0.9%		0.0%	0.8%	1.0%		11.0%	10.2%	9.3%
Office	1.7%	1.5%	1.6%		–1.2%	1.5%	1.9%		16.1%	13.7%	11.1%
Retail*	1.5%	1.7%	1.7%		1.0%	1.4%	1.6%		7.3%	8.3%	7.6%
*Represents Neighborhood and Community Retail centers **Vacancy rate at forecast-period end									Forecasts as of 3Q 2002
	Asking Rent				Effective Rent
	1-year	5-year	10-year		1-year	5-year	10-year
Apartment	1.3%	2.4%	2.9%		–0.3%	2.2%	2.9%
Industrial	–0.7%	1.0%	2.2%		–1.4%	0.9%	2.2%
Office	–5.4%	0.2%	2.0%		–7.6%	0.0%	2.0%
Retail*	2.3%	2.5%	2.9%		0.9%	2.1%	2.7%
Source: Reis, Inc.

Will Market's Gain Be REITs' Loss?

Even given positive capital market and demographic factors, the vicissitudes of the stock market may affect REIT equity returns in a manner different from the underlying economic health of the real estate. Those factors have had a lot to do with the contra-cyclical nature of equity returns to publicly traded real estate companies. Although REITs are equities, they do have a history of moving in opposite direction to market trends.

If REITs do zig when the broader market zags, will a surging stock market put REITs on the sideline? It's possible, but RERC's Riggs, for example, doesn't expect to see any "big pop" in the stock market. Instead, Riggs says he expects a slow process of recovery, which will be helpful to REITs as they remain a counter-cyclical play.

Rosen believes the difficulty in analyzing the economy right now is that we have what is called a dual economy. "We don't have an economy in recovery or recession, but we have parts of the economy in deep recession, almost depression, and we have parts of the economy that are doing very well," he says.

Economy.com's Zandi sees a market recovery having more of a negative effect on REITs. "Ultimately, the rest of the economy is going to find its footing, and investors are going to find other places to put their money. The need for safety will appear to fade, and at least through 2005, REIT stocks will under-perform the broader market indices."

David Shulman, a senior REIT analyst at Lehman Brothers, shares Zandi's viewpoint. "Lots of people say stock returns are going to be single digit and real estate is going to be double digit going forward on a long-term basis," Shulman says. "That does not make a lot of sense to me. The only way that would make sense is if there was a forecast of high inflation. If we go forward 10 years and the stock market delivers a 10 percent return, real estate delivers 8 percent and bonds deliver 6 percent, that is not a bad world."

Timing of Economic Recovery

Real estate is often labeled a lagging indicator of the broader market and other industries. Thus, much of what happens in the real estate industry going forward will be dictated by how fast and completely the overall economy recovers. Those pundits that forecast a slow recovery with corporate earnings continuing to struggle see problems for the property markets in terms of increasing—or even maintaining—occupancy rates.

"Unless we have some sort of boom to bring office demand above normal, we have got a couple of years supply that have to be taken before that market recovers," Mueller says.

The commercial real estate industry for the most part probably will experience about 18 months of falling occupancy, then about 18 months of occupancies climbing, says Andrew Florance, chief executive officer of CoStar Group Inc. "About three to five years out it could be a landlord market again. It will be about five to seven years before the (property) markets are real good again."

Economy.com's Zandi agrees that the next five years will be a transition period for the industry shaped by broader economic factors. "Unless there are major shocks to the system, such as another war in the Mid East, five years hence would begin a period of rising real estate conditions," he says.

A more bullish assessment comes from Michael Torres, president of Lend Lease Rosen. "The saving graces are that the real estate industry entered the recession in reasonably good health, capital availability has been good and there has been reasonably good discipline in underwriting."

Torres expects a gradual recovery and for the mid-term outlook, three to five years out, he makes the case that real estate continues to look attractive given the prospects for renewed economic growth and the fact that capital continues to be available.

An economic recovery also will resuscitate the struggling lodging sector. After another flat to down year in terms of RevPAR (revenue per available room) for the lodging industry in 2003, John Mattesich, a lodging analyst with Bear Stearns & Co. Inc., expects to finally see recovery in 2004.

"Demand growth will really be a function of when corporate travel comes back," Mattesich says. "Our sense is that it's going to be a little while. It is not going to happen right away. But once it does, the recovery in the sector will last several years."

However, while the unemployment rate is still fairly low at the moment, Lend Lease's Rosen believes the key to any recovery is jobs. In 2002, there was very little job creation. "If we get another big round of corporate layoffs in the near future, that will cause us to go into a full-blown recession," he says. "This would most likely lead to a domino effect as the echo boomers struggle to find jobs, affecting the market as a whole."

How all these factors play out—and how the industry responds—will dictate whether REITs will continue their strong track record of outperforming the broader markets or if the sector will see a period of diminished results. Only time will tell, but the consensus shows a confidence in the publicly traded real estate industry as a solid long-term investment.

Steve Bergsman is a veteran real estate writer based in Mesa, AZ.