By Steve Bergsman

Real estate fundamentals have lagged as share prices have soared. Will 2005 see the two aligned?

When analyzing the real estate industry, it often comes down to fundamentals—both industry specific and broader economic statistics. The consensus is that the overall economy is improving, jobs creation will accelerate and that real estate market fundamentals have begun to reverse course in a positive direction.

Why then do so many REIT executives and observers look cautiously at 2005 and beyond? "For most property types, the effects of the recession are over," says Thomas Crocker, chief executive officer of CRT Properties Inc. (NYSE: CRO).

		Top U.S. Markets Location, location, location is the recurring mantra in the real estate industry. Market fundamentals across all sectors fluctuate depending on what city, state or region you are examining.

That's the good news. The bad news is that core real estate fundamentals still have a long way to go. For 2005, Crocker predicts property performance will show modest improvement, little price appreciation for REITs and selected opportunities will arise only "where management can create value despite the challenges of the environment."

Not exactly a ringing endorsement for a new year, but the caution may be warranted. Over the past three years, the real estate investment market bifurcated. Two parts of the same industry headed in different directions: operating performance struggled while share prices soared. Except for the retail sector, most property types experienced very tough operating years. At the same time, investors sought out real estate because it was viewed as a more stable investment in the face of broader market tumult. As a result, many listed REITs enjoyed huge returns. NAREIT's composite index was up 38.47 percent in 2003 and 24.4 percent through the first 11 months of 2004.

"You had few other viable investment options, a risk-adverse investment climate and that led to people chasing conservative investments (like REITs)," notes Craig Thomas, director of research at Torto Wheaton Research. "Also, the low interest rate environment created quite a bit of liquidity so there was a lot of money chasing few assets."

Torto Wheaton Research teamed up with the Real Estate Research Corp. and Principal Real Estate Investors to issue "Expectations & Market Realities in Real Estate 2005: Navigating Through Winds of Change," which took a sector-by-sector look at where real estate fundamentals are headed in 2005 and beyond.

In the office sector, despite short to intermediate-term challenges, the longer-term prospects for office demand remain good. For the apartment market, companies have the ability to continue to generate strong absolute and risk-adjusted investment performance relative to other properties, but given current market valuation levels, selectivity and pricing discipline are critical in optimizing investment performance.

In the industrial sector, a combination of continued user consolidation, gains in logistics productivity, and increases in global trade will tend to favor larger properties in primary markets, especially those markets that play an important role in the execution of global trade and those with supply constraints, according to the report. From an investment perspective, retail centers in high population density or high population growth areas are attractive, particularly in-fill locations with supply constraints. Retail returns will be attractive over both the short and long run, given continuing strong space market fundamentals. As for the hotel sector, relatively low prices and the strong income growth potential in the sector lead the authors of the report to forecast double-digit total returns in the years ahead.

Overall, the key question going into 2005 is: Has real estate reached an inflection point where the performance of underlying real estate is finally improving, but the value of real estate, as represented in the stock price of publicly traded real estate companies, flattens?

Real Estate Cycle Status of 25 Largest U.S. Markets
Market	Office	Apartment	Retail	Warehouse	Hotel
Los Angeles	Recovery	Peak	Peak	Recovery	Peak
New York	Peak	Recovery	Peak	Recovery	Peak
Chicago	Recovery	Recovery	Peak	Recovery	Recovery
Northern New Jersey	Recovery	Recovery	Peak	Recovery	Peak
Boston	Recovery	Recovery	Peak	Recovery	Peak
Dallas	Recovery	Recovery	Peak	Recovery	Peak
Washington, D.C.	Recovery	Recovery	Peak	Recovery	Peak
Philadelphia	Recovery	Peak	Peak	Recovery	Recovery
Houston	Trough	Trough	Peak	Peak	Peak
Atlanta	Recovery	Recovery	Recovery	Recovery	Peak
Detroit	Recovery	Recovery	Peak	Recovery	Recovery
Inland Empire	Peak	Downturn	Peak	Peak	Peak
Phoenix	Recovery	Peak	Recovery	Peak	Peak
Seattle	Recovery	Recovery	Peak	Recovery	Peak
Minneapolis	Recovery	Recovery	Trough	Recovery	Peak
Orange County	Peak	Recovery	Recovery	Recovery	Peak
San Diego	Recovery	Recovery	Peak	Recovery	Peak
Long Island	Peak	Recovery	Peak	Recovery	Downturn
St. Louis	Recovery	Recovery	Peak	Recovery	Peak
Baltimore	Recovery	Recovery	Peak	Recovery	Peak
Tampa	Recovery	Recovery	Peak	Recovery	Peak
East Bay	Recovery	Recovery	Peak	Recovery	Recovery
Miami	Recovery	Recovery	Peak	Recovery	Peak
Pittsburgh	Recovery	Recovery	Peak	Recovery	Peak
Denver	Recovery	Downturn	Peak	Recovery	Peak
Source: Fitch Ratings as of October 2004. Note: Using rent, occupancy and growth information, Fitch identified a specific position in the real estate cycle for each sector in the top 25 U.S. population markets. Cycle status includes actual and forecast data from the four quarters of 2004 and first quarter of 2005.

Vacancy Rates

One of the ways to monitor real estate performance is the ability of companies to fill their properties. Job growth has picked up so leasing activity looks better for 2005, observes Robert Bach, national director of market analysis with Grubb & Ellis Co.

"In my business, you need a growing economy that actually produces office jobs in order to fill our office buildings," Crocker says.

Just don't get too excited about initial improvements in occupancies, because "we are only in the first or second inning of a nine inning game," Bach adds. "It's going to be awhile before vacancy rates come down and it is a landlord's market again."

For 2005, Reis Inc. predicts: apartments will decline in vacancy, rise in absorption and rents; industrial will decline in vacancy, experience a big jump in absorption and commensurate rise in rents; office will see vacancies drop and enjoy a big jump in absorption and commensurate hike in rents; and retail will suffer a rise in vacancies, but still show small increases in absorption and rents.

The office market has experienced some of the toughest fundamentals in the real estate market. While he agrees that office vacancies are beginning to show improvement, there is a concern that new office completions will offset the progress in reducing vacancies, says Kenneth Riggs, CEO and managing principal of Real Estate Research Corp.

"The office market has a long, hard road to a space market recovery," Riggs says.

Riggs adds that 2005 looks better for apartments on a risk-adjusted basis due to job growth, demand from Generation Y renters, and rising interest rates pushing demand from those who want to be homeowners to those who must rent.

NOI and NAV

Tied to vacancy rates, one of the key operating metrics for investors analyzing REITs across all sectors is net operating income (NOI). While vacancies may be declining as new tenants move in, rents are still falling, especially for office and industrial, because lower levels of lease rates formed in given markets. This is especially true where older leases are rolling over. Many of these leases were originally written during the boom years when space was tight and rates were sky-high. That's no longer the case and could threaten NOI for a number of REITs.

"The hardest thing will be for companies rolling leases," according to David Loeb, managing director of real estate research at Friedman, Billings, Ramsey Group Inc. "If rents decline from old leases it will be difficult to show any kind of rent growth."

The market is starting to see NOI being adversely affected by leases rolling over to lower market rents in sectors like office and industrial, observes Thomas. As an example, for the third quarter 2004, Equity Office Properties Trust's (NYSE: EOP) same-store NOI decreased 6.4 percent, as compared to the third quarter of 2003.

"What we are telling clients is that you have to be very selective and careful to watch NOI because this is not going to be a rising tide of asset values," Thomas says.

Fundamentals have hit bottom and in most cases markets are improving. Nevertheless, Thomas cautions not to get excited because there are significant NOI problems in formerly high-flying markets like Boston, San Jose and San Francisco.

Looking at NOI from a different perspective, Steve Sakwa, first vice president with Merrill Lynch & Co. Inc., says that although NOI growth remains modest, cap rates continue to decline as capital flow remains brisk. "Our view is that even if long-term interest rates rise modestly from current levels (which may push cap rates higher), NOI growth will improve which should allow asset values to remain relatively stable over this period," according to Sakwa.

Sakwa focuses considerable attention on the net asset values (NAVs) of REITs. As he notes in a recent market report, after experiencing little NAV per share growth between the middle of 2001 and early 2003, NAV expansion picked up steam as capital flows into real estate increased. As of the second quarter of 2004, the overall REIT sector generated NAV per share growth of 23.7 percent. Regional malls, self-storage and neighborhood centers were the hottest sectors, all up 29 percent or better.

However, Sakwa adds, with the 10-year Treasury hovering around 4 percent and cap rates probably reaching bottom, future NAV per share growth will need to be generated from accretive acquisitions, value-added developments or NOI growth.

If NOI growth looks problematic, what about the other drivers, such as accretive acquisitions?

"With cap rates as compressed as they are, making accretive acquisitions based on cost of money has become more challenging," says Dennis Gershenson, president and CEO of Ramco-Gershenson Property Trust (NYSE: RPT). "That makes it incumbent on REITs to get more creative in finding ways to increase their yields on the new dollars they are investing." One way to do that, Gershenson adds, is to reposition and redevelop core assets.

Interest Rates and Cap Rates

Gershenson's outlook on real estate market fundamentals might be more positive than some because his company operates in the retail sector, which has been on a strong run the past three years.

Because market fundamentals in retail remained stronger than other sectors, many investors flocked to retail, driving down cap rates and competing with REITs for property acquisitions.

"With interest rates as low as they have been, private investors have been coming into the sector, competing with public companies and institutions for shopping centers," Gershenson says. "They can leverage money in the 4 percent range and be willing to pay for an investment with a cap rate in the 6 percent to 7 percent range."

As for 2005, Crocker says, "cap rates can really move either way." To which he adds, "I suspect over time we will look back and be able to correlate these really low cap rates to historically low interest rates."

Harvey Green, president and CEO of Marcus & Millichap Real Estate Investment Co., takes a slightly different stance on the cap rate issue. "There is still product scarcity in the broad real estate market with more dollars chasing fewer deals. A downward pressure still exists on cap rates," he says.

Nowhere more so than in the retail sector. "Everybody wants to own the supermarket-drug store anchored, neighborhood shopping center," Green says. "It is an excellent portfolio piece with long-term stability. Besides the anchor leases you have the upside of the in-line shops to support additional revenue."

Cap rates for many Class A products have been down in the low 6 percent range. That's generally not where the REITs would like to buy, but Green says some REITs have bought near the 5 percent cap rate.

The Real Estate Research Corp. projects the following going-in (first year NOI divided by purchase price) and terminal (similar to going-in, but applied at the end of holding period) cap rates for 2005:
• Going-In: CBD office, 8.1 percent; suburban office, 8.5 percent; industrial warehouse, 7.9 percent; industrial R&D, 8.9 percent; regional malls, 7.4 percent; power centers, 8.3 percent; neighborhood/community centers, 7.7 percent; apartments, 7.2 percent; and hotels, 10.3 percent.
• Terminal: CBD office, 8.6 percent; suburban office, 9.1 percent; industrial warehouse, 8.5 percent; industrial R&D, 9.4 percent; regional malls, 8.0 percent; power centers, 8.8 percent; neighborhood/community centers, 8.2 percent; apartments, 7.9 percent; and hotels, 10.8 percent.

This competitive market isn't forecast to change significantly in 2005 because money will still be cheap. Although the Federal Reserve increased interest rates in 2004, they are still relatively low. "Interest rates aren't going up more than 75 to 100 basis points in 2005," Green says. "They are not going to be an issue."

The benchmark overnight lending rate as of mid-December 2004 stood at 2.25 percent, following a fourth small rate increase since the Fed started tightening monetary policy at mid-year.

Hans Nordby, a research strategist with Property & Portfolio Research, takes an alternative view, suggesting interest rates and cap rates are interrelated. "As interest rates rise, the question is how will cap rates react in comparison. We don't expect a one-to-one race between interest rate increases and higher cap rates, but there should be some effect," Nordby says.

"When you look at cap rates you need to look at interest rates as well because it is not just about cap rates or interest rates in isolation from each other, it's about the spreads between the cap rates you pay for the property and the relevant interest rate (mostly the 10-year Treasury) benchmark," Nordby says. "When times are good and occupancies are strong and getting better, spreads tighten because investors rightly perceive less risk in the investment. When vacancy rates are high or rising and rents are headed in the wrong direction, investors need to get compensated for a higher level of risk, as a result spreads widen."

Of all the real estate sectors, the one most directly affected by the low interest rates of the past few years has been multifamily. With borrowing so cheap, many renters have opted instead to become first-time home buyers.

"The challenge we have in the apartment sector is that we are in a low interest rate environment, meaning you are going to end up in periods of increasing and continued pressure from home ownership," says Thomas Toomey, president and CEO of United Dominion Realty Trust (NYSE: UDR).

As for 2005, Toomey predicts short-term interest rates are going to remain low and long-term interest rates are going to rise. Cap rates for United Dominion will be 6.5 percent to 7 percent for dispositions and 5.7 percent to 6.25 percent for acquisitions in 2005.

While the apartment sector saw the stirrings of M&A activity in 2004, with Camden Property Trust (NYSE: CPT) acquiring Summit Properties Inc. (NYSE: SMT), Toomey expects market fundamentals should lead to more of the same in 2005.

"The extremely low interest-rate environment means the cost of debt is very low so it is an attractive opportunity to lock in debt and buy into assets that are growing," he says.

Moving Forward

It's very difficult to predict the fate of the REIT sector for 2005 as separate parts have been moving in different directions for a long time. Actual operations have performed poorly over the past few years, but stock prices have been up. Real estate fundamentals such as occupancy rates should improve in 2005, but NOI could be problematic. In general, the economy could untrack next year, but REIT prices may have already peaked and could slip backwards. Finally, some REIT sectors such as office still face a long slog ahead, while others such as retail could continue to cruise.

"I think 2005 will be a recovery year for the economy and all property types," Nordby says, "with the exception of retail, but that's only because it fared so well during the recession years so it seeks no recovery."

For the past couple of years, the broad market and the economy have combined to produce a very challenging environment for real estate, concludes Riggs. Nevertheless, REIT share prices have climbed because, as Riggs maintains, real estate is proving to be a very attractive long-term investment.