"Emerging Trends" Survey Finds Investors, CRE Execs Adjusting to New 'Era of Less'

Investors have tamped down their expectations for over-sized returns in 2011, adopting a back-to-basics approach as debt markets continue to thaw and value-add and distressed sales opportunities gradually build momentum next year, according to respondents to one of the industry's most widely watched surveys.

Real estate executives surveyed for Emerging Trends in Real Estate 2011, a joint report by the Urban Land Institute (ULI) and PricewaterhouseCoopers (PwC), expected 2011 returns to be in the high single digits, 7.5% unlevered for institutional-quality private real estate and 8.2% for REITs. Most of those increases will be driven by modest gains in property-level income and appreciation, with larger returns for trophy properties in prime markets. But the effects of three long years of pain won't disappear overnight.

"After a 30% to 40% loss, it could take a long time to make up ground," commented one respondent.

Gradually, extreme negativity in commercial real estate will subside -- though not before lenders and borrowers finally start to accelerate their loan workouts and accept loss haircuts of up to 50% on the inflated values of assets buyers purchased during the commercial real estate price bubble that preceded the recession, according to the report. ULI and PwC interviewed or surveyed more than 875 professionals representing a broad range of industry experts, including investors, fund managers, developers, REITs, lenders, brokers, advisers and consultants. Many have become more realistic about their predicament over the last 12 months, seeking shelter in real estate's value relative to other asset classes.

"The recent lesson learned is that real estate is a low-operating-leverage business," an interviewee said. "It’s very hard to get 15% to 20% rates of return without more risk and more leverage, and you can’t succeed on a sustained basis. Real estate is more about cash flow and keeping buildings leased."

"You can no longer make money off flipping; you must be able to manage assets at the property level," one interviewee noted.

Survey responses point to improved prospects off last year’s rock bottom for all U.S. property markets and sectors. The ongoing rush to acquire core assets will bring a modest recovery for owners of warehouses, downtown office properties and neighborhood shopping centers -- but more limited gains for malls, power centers and suburban office property. Apartments, meanwhile, will strengthen as the ultimate income-generating plays, easily outranking all other sectors due to favorable demographics, increased renter demand due to the housing bust and reliable Fannie Mae and Freddie Mac financing. Here's a quick look at comments from survey respondents on the main property types:

APARTMENTS

"You sense improving fundamentals with legs at least to mid-decade."

Ready leverage through the GSEs at or near market bottom could turbo charge multifamily returns in the up cycle. "There’s no way you’d pay [current] prices without low rates and available financing."

Respondents called low-risk, low-return apartments "the safest bet" through the cycle and "the new gold standard" for institutional property portfolios.

Rising demand in core assets compresses apartment cap rates to uncomfortably low levels, down 200 basis points in some markets. "Anything top-quality gets people frenzied," says an interviewee.

Multifamily players worry about what Congress will do with Fannie and Freddie. "Any [agency] reformulation will raise spreads, and originators must have more skin in the game."

As long as developers and construction lenders check their appetites, apartment investors should benefit "with the wind at their backs."

INDUSTRIAL

More than 90% of survey respondents favor buying or holding warehouses in 2011, despite record-high vacancies and continuing rent drops.

Despite reduced concessions, landlords will not gain pricing power again until late 2011 or into 2012 once occupancies increase above 90%. "We’re dealing in a more drawn-out recovery with not enough demand to push rents."

Depending on oil prices, more long-haul cross-country distribution could shift from trucks to railroads. "This could mean new distribution centers served by trains and shorter truck trips." The longstanding trend toward "fewer and bigger distribution centers may be in for a change."

Investors need to take greater care in placing their industrial bets. A "challenging and changing market" features "a ton of functional obsolescence," especially in shipping hubs where large tenants want taller and taller buildings.

Hammered rents cannot "justify development, except for the odd build-to-suit."

HOSPITALITY

All key hotel metrics show improvement. "Hotels have the most flexibility to increase rates and can come back fastest."

Operators "were geniuses at cutting costs" during the downturn, putting fewer towels in rooms, eliminating nighttime turndown service. "After the worst slump in decades, the outlook can only get better." Business-center hotels in gateway destinations "can get some pop."

"Chocolates are back on pillows."

Skittish lenders show little interest in providing financing to buyers. "There’s no such thing as a safe loan on a hotel," says an insurance executive. "If you want to play, you might as well just own them. They are businesses, not property investments."

"Over the course of any decade, there are two years to buy hotels and two years to sell them. Now is the time to buy."

But hotel performance correlates closely to gross domestic product (GDP) growth, and a long economic recovery bodes for a more-sluggish resurgence in lodging. "This sector is not for the faint of heart. You need a good operator."

RETAIL

"Low expectations haven’t been met," and shopping-center investors regroup. "We’re now realistically confident we can get through this rough period."

Retailers closed weak stores and shed more than a million jobs and now realign in the best locations, benefiting fortress malls and prime infill community/power centers. "Tenant seepage has stopped," at least. Owners of good retail centers with high-credit tenants can secure financing. "I’m surprised by how well it’s held up."

"Levels of concessions have been unprecedented. Malls look full, but owners forgive back rent, cap CAM [common-area maintenance] charges, or just let stores stay open without paying anything."

Sales start to increase as shoppers concentrate in surviving locations, but overall, they don't spend enough and "we’re limping along."

Strong centers poach tenants from weaker malls. "It [poaching] is open and notorious."

Some gross leasable area will be wiped out across the shopping center landscape, anywhere from 5% to 10%. "If you drive around some suburban neighborhoods, everything is empty."

Malls and power centers now lure supermarket chains into empty anchor locations, another blow to some shaky community centers. Internet retailing is taking more share away from bricks-and-mortar stores. "People continue to spend less time in malls."

Development is nil, and for the first time since the early 1950s, no regional malls are under construction in the United States.

"We have the opportunity in this hiatus to rethink how we deliver retail in better transportation- linked urban centers, moving away from car-dependent models."