Executive Insights A frequent topic of discussion at NAREIT’s Annual Convention was where we are in the real estate cycle.

Kenneth Rosen: Believe it or not, I actually like the office sector because we are seeing net absorption and we're not seeing new development yet. I also like hotels. Again, mainly due to limited new supply.

Photo: John Kringas

This looks like it’s going to be the first year (2005) in a long time where the mall sector is not the performance leader among REITs, and I wouldn’t be surprised if that’s the start of a trend. —MIKE KIRBY

Mike Kirby: Because I'm pessimistic on the outlook for housing and the ensuing ramifications for consumer spending, I don't picture the mall sector doing anywhere near as well as it has done. This looks like it's going to be the first year (2005) in a long time where the mall sector is not the performance leader among REITs, and I wouldn't be surprised if that's the start of a trend. Of course, that same argument steers us to the office and apartment sectors for the natural overweights.

But my problem with the apartment sector is that the cap rates have been pulled down more than in any other sector by the tune of 30 to 50 basis points. That has to do with the fact that when a company like Scot's Archstone-Smith goes and buys properties, it's not just competing with other REITs but also condo developers. So there's a cap rate issue there that makes me feel uncomfortable with the sector right now in terms of an overweight.

However, I agree with Ken that the office outlook is not bad and could improve further if job growth continues at the pace seen in 2005. I also think we'll continue to see very limited new construction because of the high construction costs today, which are up almost 20 percent in the last year.

Photo: John Kringas

Years ago when I started doing research for portfolio allocation work, I found instead of looking at real estate in terms of regional impact it was more valuable to look at local economies and the industries that were driving that economic base. —GLENN MUELLER

Glenn Mueller: Hands down, the apartment sector has the best supply/demand fundamentals going forward because the echo boom generation is now getting out of college, getting their first jobs and renting their first apartments. Assuming that the economy continues to improve, we've got a 10-year period where a half million people are coming into that 20-something renter cohort that creates strong fundamentals for the sector. The problem is pricing. Apartment prices are so high today that it almost takes your breath away.

Another trend that could work in the sector's favor is rising interest rates. The average age of a first-time home buyer in 1990 was 36 years old. That recently dropped to 32 years old because declining interest rates allowed people to afford to buy sooner. If interest rates continue to rise, that age will be pushed back up. That means more people will rent longer.

Jonathan Litt: Our thoughts have evolved over the year. Our focus has been more on geographical regions as opposed to property sectors. We like the office and apartment sectors, but we like those in the New York, Washington, D.C. and Southern California markets. They have the best fundamentals right now; supply and demand is in the best shape. These companies trade at 20 percent to 30 percent premiums but these are the ones that are going to demonstrate the best growth, probably in the near term but definitely over the long term. On the flip side, we would tend to avoid apartment and office companies in the South.

The retail malls and strip centers are going to face a headwind due to concerns about the consumer. Fundamentally, occupancies are likely going to be flat. We're not going to see that 50 to 100 basis point increase in the mall companies we have seen in recent years, but we're not going to see it fall off a cliff unless the consumer is really wiped out.

In the industrial space, you're not buying warehouses anymore, you're buying merchant developers. With the exception of one company, they're all in the merchant development business—and that's a highly cyclical business. The largest industrial REIT has seen its development pipeline go from $600 million to $2 billion. And that's driven by growth in the global economy. If we see a global recession, that development pipeline is going to come down and their earnings growth is going to get hit, I believe very hard.

Right now the growth prospects look great because those development pipelines are expanding, but investors have to be quick to pull the trigger if they see that global recession on the horizon and get out of those names.

Sellers: Now let's shift to regional outlooks. Which markets do you find favorable or unfavorable in the coming years?

Photo: John Kringas

Both in the long and short term, investors want to be in a market like New York, where there is real supply constraint. Over the long term, you’re going to be able to grow the value of those assets at a much greater rate than inflation. —JONATHAN LITT

Litt: Both in the long and short term, investors want to be in a market like New York, where there is real supply constraint. Over the long term, you're going to be able to grow the value of those assets at a much greater rate than inflation.

If you go to Dallas, Houston or Atlanta, it is much harder. As soon as construction costs get to the level that justify new construction, you're going to see building, and if you assume that construction costs go up with inflation, the best you're going to do in those markets over the long term on your real estate is inflation-like returns. While it is best to avoid those markets over the long term, they're great to play in the short term because they get overbuilt, then they get oversold, and then there's an opportunity to get back into it.

Mueller: I don't look at things on a regional basis. Years ago when I started doing research for portfolio allocation work, I found instead of looking at real estate in terms of regional impact it was more valuable to look at local economies and the industries that were driving that economic base. By doing that you could see that San Diego and Norfolk, Va. were similar because of the fact that they had military bases driving their economies.

Over the years, that has changed. This country went from an agricultural society to an industrial one to now being a service economy. And the big question is what's next? The author of the book "The Rise of the Creative Class" says the next big trend is the creative class making decisions, including where to live, based on quality of life. They want to have a nice environment, but they want to have a place that has a lot to offer culturally. Even after they graduate from college, the new young creative class still likes to stay up late and enjoy life. And if they're living in a town that doesn't offer that, they're not going to want to stay.

The book ranks 14 U.S. cities as the key destinations for this creative class. Northern Colorado, Denver, San Francisco and Washington, D.C. were all on the list. And it's those types of cities tied to high standards for quality of life that should thrive in the long term.

Kirby: Over the long term it's impossible to disagree with the thesis that New York, the Northeastern seaboard and the California coast are among the top markets in which to invest. More often than not over the past five to 10 years, while those markets have been priced to reflect some of that, they've seldom been priced low enough on a cap rate basis to reflect all of that.

And that range tends to fluctuate. A year ago in the apartment sector, the cap rate spread between a Dallas property and one in a coastal market was so tight it was just downright goofy. That has widened a little bit now to the point where it's a little more rational.

Our bias is heavily toward the coastal markets and has been for quite some time. But I would throw one caveat in there: In the short run, watch the markets that have housing issues. Southern California is a great place long term, but you have to question what the real estate economy will look like over the next three years. So there are certain housing bubble markets that we're nervous about and that we're starting to think about in pricing the stocks, but it's only a few property sectors where that's a real big issue.

Over time, I think Florida is going to continue to do very well because people want to retire there. But short run, the entire state is one big building boom and there is going to have to be a correction. —KENNETH ROSEN

Rosen: We're long on Seattle, Minneapolis, Southern California, Washington, D.C., and, obviously, New York. We like Boston, San Francisco and Austin, Texas because we think they are in a big cyclical rebound. We're short Phoenix, Las Vegas, Miami, Atlanta, Dallas and Houston.

The common theme is that investors should look for supply constraints and places that might be in a cyclical recovery like San Francisco, Boston and Austin. But quality of life, as Glenn said, is the long-run theme. Over time, I think Florida is going to continue to do very well because people want to retire there. But short run, the entire state is one big building boom and there is going to have to be a correction.

Sellers: Parting shots; what should investors look for in 2006?

Litt: We are looking for REIT returns to be flat or down this year (2005). I think that if we get that kind of a return environment we'll be better positioned for next year (2006). The backdrop of a global economy, the U.S. economic climate and inflation are creating an enormous amount of uncertainty.

Mueller: Funds are being allocated into real estate where many investors have never been before. It's now considered a separate asset class, and I think that's good for all of us. Most institutional investors are still just trying to get up to their minimum allocations in many cases, or if they have an allocation range they may want to be at the bottom of it. But those funds are here to stay. And there is another $50 billion looking to make its way into private real estate investments and REITs.

The stock market is always emotional in the short term; we've seen interest rates rise a little bit and the REIT market corrects and within two weeks to a month it's back up. Short term, I think we're going to have a lot more volatility, but long term the real estate allocations are there and that sets our price floor. So I'm definitely bullish on the sector. I think REITs probably end the year with returns in the 5 percent to 10 percent range.

Kirby: A low return world is no fun, but we're in one, and we're going to be in it for quite some time. We have enormous deflationary forces across the globe that are going to be keeping us there for the next 10 years. And while our generation has never lived in that environment before, historically it's not that unusual.

Low returns over the very, very long-term time span are the norm. And the low-return world is a great backdrop for real estate securities because if the 10 year-Treasury is slated to bounce between, say, 3.5 percent to 5 percent, for the next 10 years, 6.5 percent cap rates for real estate aren't bad.

Rosen: I would say that given the uncertainty in the REIT market, now is the time to be tactically defensive and hedge your bets. That's what we've done, and we think it's the right strategy, focusing on those sectors that might be weaker to be on the short side and be long on those great companies. Once this re-pricing takes place, which we think may take as long as two or three years, we're looking at a very decent return from the sector. We look at 6 percent to 9 percent as the range for long-term returns, and I think that's a really good place to be.