Ernst & Young Real Estate Prognostications for 2005
The quotes below were taken from Ernst & Young professionals around the nation.
Everyone is an investor.
In 2003, we predicted RE market growth would be led by private investors, but even we were amazed by the depth of activity in 2004. Perhaps the fact that wealthy individuals worldwide are believed to hold US$4.9 trillion in real estate has something to do with the private market frenzy that looks set to ride well into '05. Or maybe it was the fact that 55 percent of Gen-Xers included real estate investments in their financial plan? Conservative estimates suggest that "high-enders" may invest a further US$1 trillion or more in real estate worldwide by 2008. In fact, the reemergence of the individual investor is exhibited in the trophy office sector where two major landmarks - Chicago's Sears Tower and San Francisco's Bank of America Center - moved from institutional to private hands in '04. While some industry observers may question the longterm viability of some of these highly leveraged deals, expect more such deals to follow in '05 as long as financing remains plentiful and relatively cheap. Dale Anne Reiss, 212 773 4500.
Privatize? Well, it's just plain cheaper.
In last January's letter we said "while the cost [of implementing Sarbanes-Oxley (SOX) and other financial reporting requirements] alone probably isn't enough to push public companies in real estate to privatize, it could be viewed as one compelling argument for privatization in a broader debate." By summer '04, more than a dozen public real estate companies had announced plans to privatize or merge with larger public peers and, in many of these decisions, CEOs cited the rising cost of compliance as a contributing factor (eg. Summit Properties and Camden Property Trust). As SOX and financial reporting -particularly Section 404 --costs continue to climb (last year's estimate of three to five cents per share erred on the low side), more companies, including foreign firms doing business in the U.S., may pursue privatization, joint venture, or merger strategies. Dale Anne Reiss, 212.773.4500; Rich Jeanneret, 703.747.1281
Condo Hotels: You better have my room available from now on!
In an upcoming pre-release of Ernst & Young's annual lodging study (www.ey.com/us/realestate), the E&Y hospitality practice points out that time shares aren't the only hotel-like, part-time vacation housing choices being offered to baby boomers. The "condominium-ization" of large central business district hotels and properties will be even bigger next year in the U.S. -- not only for boomer buyers, but businesses as well. Condominium-hotel debt is "outsourced" to individual investor equity or mortgages by unit purchasers rather than more traditional financing sources. For boomers, condominium-hotel units offer vacation homes or "pieds a terre" with the services and amenities of high-end hotels. When not using units, owners may opt to place them in rental programs that help to defray the cost of ownership. Paula Morabito, 305.415.1487; Mark Lunt, 305.415.1673.
Beyond 404: A chance to become really efficient?
By Spring '05, investors will see the first public RE company financial reports carrying opinions on the adequacy of their internal systems and controls. Section 404 of the SOX Act truly breaks new ground in company reporting and the increased transparency should prove a boon to investors. Savvy management will look to 404 as a wake-up call and use the opportunity provided by the legislation to really get their arms around how their companies operate, where the deficiencies and weaknesses lie and how they can be remedied. Those that do will create more efficient RE operations, minimize risk and maximize cost savings and revenue enhancement. John Heywood 213.977.3237
Weak dollar = Foreign buying boom
German investors were the biggest foreign buyers of US real estate in '04. By midyear, purchases by German funds exceeded $4 billion, almost 10 times the level of investment activity posted by any other foreign player. Yet, German investment in the US slowed toward the close of '04 -- due partly to the fact that cap rates on major deals have tightened so dramatically that going-in returns are inadequate for many syndication funds. (A proposed change in the IRS Code relating to the accounting treatment of large partnerships may also temper the German appetites.) Of course, the decline of the US $ against several foreign country currencies, notably the British pound and the Euro, may lead to further German and European purchases - it's already fueling a buying frenzy in New York City where foreigners are snapping up high-end condos at effective 35 percent discounts due to the weak dollar. Australia also looks to be a good bet for U.S. activity. The need for Australian pension funds to put capital into real estate outside the country makes the U.S. a major target. Gary Koster, 212.773.0525; Sandy Presant, 310.551.7805
Health Care construction cost overruns are…scary.
Higher costs aren't the only thing giving a migraine to the health care industry. In fact, even more alarming than the huge increases in materials costs for constructing new facilities are the huge cost overruns that have been created simply by the absence of systems in place for monitoring and controlling costs. What was supposed to be a $30 billion tab for updating and new construction this year now looks more like $45 billion, and counting. This in an industry always strapped for cash. Nowhere is the prospect of huge cost overruns as problematic as in California, where hospitals are required to comply with stringent seismic regulations - with an absolute completion deadline now in less than five years. In fact, retrofits would be easy if the essential infrastructure of healthcare facilities were not so outdated. Most health care professionals expect huge real estate-related problems over the next 5 or 10 years, even without a major quake. Jon Winer, 212.773.8112; Mike Whalen, 415.894.8000; Peter Shannon, 312.879.6648.
Bubble, anyone?
In September 2004, the International Monetary Fund warned UK homeowners that house prices in the United Kingdom were 15-20 percent above "realistic" levels. What, then, would the IMF make of Fortune's September 20 cover story spotlighting 28 major U.S. housing markets in which home prices exceeded incomes by more than 15 percent? More disconcerting than the run-up in prices in the U.S. is the proliferation of little or no money down mortgage programs, interest-only adjustable-rate mortgages and aggressive home equity loan programs. Even a slight increase in interest rates could lead to a hefty increase in the foreclosure rate -- and a dramatic "drag" on the economy. "Bubble" talk is a global phenomenon that won't die down in the near term. Steve Friendman, 703.747.1940; Dale Anne Reiss, 212 773.4500.
Storms may come and go, but will the memory fade?
According to FEMA, 75% of the nation's homes are in areas vulnerable to flooding, hurricanes, earthquakes or major storms. While actual damage to commercial real estate markets in the Southeast wasn't as bad as first anticipated after '04's hurricane season (total insured property losses still hit $26 billion), predictions of more frequent big storm seasons mean there is likely to be adoption of stricter building codes, especially in the hardest hit areas in Florida and Alabama. One certain development: wider requirements for windows rated to withstand up to 140 mph winds. The severe storm season also did nothing to stop the steady increase in insurance costs that have been plaguing the real estate sector. But, more important, look for a subtle shift in investment patterns away from the Southeast, especially among so-called "Empty Nesters." Las Vegas, NV, is already rivaling Florida by appealing to seniors; New York City, too. As one of our team notes: "Instead of playing shuffleboard in God's Waiting Room, Nesters are now buying tickets to Lincoln Center." Dale Anne Reiss, 212.773.4500; Steve Friedman, 703.747.1940
It's "converting condos" time again.
Don't expect the latest trend of converting rental apartments to condominium ownership to end anytime soon…at least, not until mortgage rates move up by more than a couple of percentage points. In fact, look for more conversions in high priced housing markets on both coasts - San Francisco, Los Angeles, Boston, New York, Washington DC and Miami are off and running, but converting has also taken hold in other major urban areas such as Chicago and Houston -- so much so that even multifamily REITs are getting in on the act. The broad availability of financing for developers and low rates for home loans makes this a hot trend. Steve Friedman, 703.747.1940; Dale Anne Reiss, 212.773.4500
Global REITs come in many flavors.
Look for a proliferation of tax-deferred public real estate vehicles - many styled on the U.S. REIT - in a variety of jurisdictions around the world in 2005/06. In the U.K., legislation creating property investment funds (PIFs), - designed to create a more liquid, tax-efficient market in property investment for private investors, could be realized in 2006. A similar move last year in France has paid immediate dividends with several public companies converting to SIIC (REIT) status, despite having to take a one-time tax "hit" upon conversion. In Hong Kong, the Housing Authority has targeted January '05 for creation of the world's largest REIT when it divests its HK$20billion shopping mall and parking portfolio. The Japanese REIT market has grown to about $14 billion in 14 REITs in just four years and Singapore boasts REITs worth about $3 billion. In fact, some observers believe Asian REITs are about to "take off" and that the REIT sector could be worth $140 billion by the middle of the next decade. 2004 saw the creation of the first global REIT Index. Look for global REIT funds to proliferate in '05. Contact: Les Loffman, 212.773.1457.
Will governments rethink property fire-sales?
Last year we pointed to what we said would be a growing trend: states using sales of excess real estate to help bridge their widening budget gaps. (They aren't just selling real estate; several states have auctioned off excess state equipment in low-cost Internet auctions.) Several states and municipal authorities are mulling real estate disposition plans, but could they be leaving money on the table? A recent proposal by California State Treasurer Phil Angelides would create a $5 billion higher education endowment using state-owned real estate assets. If approved, the endowment would be the fifth largest in the country and the only one entirely funded by real estate. Key to the proposal: assets would be selected for their development and re-use potential in partnership with the private sector, creating a revenue stream to fund education by adding value to the state's portfolio, not just selling it. In New York City, the Metropolitan Transportation Authority announced a plan to raise $1B by selling development and air rights on the more valuable of its 14,000 properties. Investment programs like these would also create opportunities to develop affordable housing and mixed use in urban infill locales. Regardless of how they implement, we think other states will take a more strategic approach to unlocking value from their real estate in '05. Michael Straneva, 602.322.3610; Peter Brooks, 212.773.4976; Darin Buchalter, 415.248.2008
The insatiable appetite for deals will get even crazier next year.
Last year, we predicted that the biggest driver in the real estate sector would be job growth. Wrong. The biggest drivers were an insatiable appetite for income and an abundance of cheap debt. Twice as many properties traded in the first 8 months of '04 as traded in the whole of the prior year. Interestingly, fully 50 percent of the nearly $100 billion in trades as of September 2004 were in the office sector, despite the fact that job growth failed to materialize as robustly as expected. Capital is plentiful. In 2003, we estimated $16 billion in capital was waiting to be invested by real estate private equity funds -- and predicted that these funds would raise an additional $20 billion in '04. We're still counting, but we think they raised much more. Private REITs raised $8 billion in '03. Foreign investors invested more than $10 billion. With private investors in a buying frenzy and pension funds at five-year highs, competition will remain at a fever pitch in '05. Gary Koster, 212.773.0525; Sandy Presant, 310.551.7805; Dale Anne Reiss, 212.773.4500.
More corps move to unlock value in real estate.
In 2004 we told you to expect more corporate real estate transactions known as "balanced portfolio sales." In these deals, corporations bundle excess real estate and, instead of selling assets piecemeal, offer a package - $100M or more - to the global investment community. It's a tactic that caught on primarily because of the huge amount of capital seeking real estate. Several notable "balanced portfolio" transactions occurred in '04 with financial services firms such as Bank of America and Charles Schwab leading the way in creating these appealing structures and offerings. But the portfolio approach lends itself to many industry sectors. (In the U.K., grocery chain Tesco completed a major sale last year.) We think that in '05 more global corporate owners will take advantage of this innovative way to monetize real estate without losing control outright. Mark Smith, 212.773.7990; Darin Buchalter, 415.248.2008
Accounting rules may not be so boring after all.
Look for increasing pressure on the U.S. to move toward adopting some, if not all, of the international accounting standards in 2005. A 2004 survey of 59 countries found more than 90% of these global economic players intended to conform their local accounting practices with International Financial Reporting Standards. The new standards are already being adopted by the European Union. Widely accepted international standards could help a growing community of global real estate investors make better-informed investment decisions, but there's a long row to hoe before US GAAP and IFRS can converge. Investment techniques like the sale/leaseback might become difficult, if not impossible. David Sawaya, 415.248.2006; Ad Buisman, (Netherlands) 31 55.529-1428
Homebuilders take on more risk
A limited supply of land in key markets around the country (California, Florida, the Northeast) is leading more large public homebuilders to acquire land earlier in the entitlement process and thereby assume greater risk. Net result: more risk for major homebuilders begs the question -- do investors understand the additional risk these companies are now taking on? Also, look for more consolidation in the industry as public homebuilders buy up smaller players with land pipelines, lot entitlement and finished pad experience. Steve Friedman, 703.747.1940; Michael Gillmore, 213-977-3232
E&C market: Cautious optimism for '05
A recent meeting of engineering and contracting CFOs in Las Vegas displayed cautious optimism for the sector in '05. This, despite dramatic increases in virtually every aspect of the engineering and construction industry -- from raw materials (steel prices up 50 percent to 100 percent; rebar prices up 100 percent; cement prices up 30 percent to 50 percent; copper wiring and conduit prices up 100 percent to 250 percent.) to insurance and bonding. None of these areas is likely to see prices ease anytime soon, especially in materials - thanks largely to high demand from the hurricane-damaged Southeast. As a result, contractor pricing is very competitive and margins are thin. Look for more joint ventures between E&C firms - even the majors - on large projects, to offset the high cost of doing business. .Mike Lucki, 310.785.4018
Less jobs, more space…available.
Let the politicos argue about job growth. The fact remains that business section headlines in '04 referred more to job cutbacks than to job creation. If it wasn't a company "offshoring" jobs outside the U.S. it was companies announcing major layoffs. Increasingly, companies are realizing that real estate savings are also created through shedding jobs. In October 2004, Nortel Networks cut 2,650 jobs in North America and 650 jobs in Europe, citing a "direct impact" on its 2 million SF real estate portfolio. As the economy turns, corporations have a unique opportunity to align their real estate with their business strategy, so that they don't take on too much real estate liability too early (or hold on to it too long.) Dale Anne Reiss, 212 773 4500; Mark Smith, 212 773 7990.
China's growing infrastructure is mind-boggling
China is pursing the largest public works program since the U.S. went through the New Deal in the 30's. By 2010, China will spend upwards of $23 billion on more than 100 major infrastructure projects from state highways to airports. As China's infrastructure develops, look for more foreign firms to shift back office functions - now headed mostly to India -- to China. Meanwhile, planned disposals of nonperforming loans burdening China's banks could signal an end to Asia's era of distressed debt and fuel a local real estate renaissance. Jack Rodman, 86 10 6524 6688 ext. 3354; Dale Anne Reiss, 212 773-4500
Restaurants look to cut costs, as well as carbs.
Successfully managing rising operating costs will be one of the key issues facing the restaurant sector in '05. From energy costs - currently averaging $2.90 per SF for electricity and $0.85 per SF for gas on an annual basis - to rising employee costs - restaurants face an uphill battle. Changing consumer tastes are a major issue: will the low-carb fad now affecting the industry persist? Operators face a challenge in how far to follow today's fads into tomorrow. Contact: Michael Gottlieb, 949.437.0290; Carl Marano, 602.322.3626.
Gaming: Growing the business without betting the farm.
The growth of the gaming sector is fast becoming a global phenomenon. Even the U.K. (which started the whole Vegas defection trend with its Playboy Club in the 60's) is again jumping on the casino bandwagon, with new casinos planned in and around London. In the U.S., however, the expansion of casino gaming continues to provoke controversy, especially in the proliferation of Indian gaming casinos in California. The larger issue for the industry may be consolidation: with several mega-mergers in '04, many big players will take a long look at their revenue and costs structures in '05. Contact: Brian Ford, 215.448.5010; Pat Pruitt, 215.448.5679
Retail: Watch this space.
Don't read too much into the lackluster start to the '04 holiday shopping season. Much has been made of consumer confidence and its impact on the retail sector, but the fact remains that the National Retail Federation is still projecting a 4.5 percent gain in retail sales over last year's holiday season. More important to the retail real estate sector is the potential impact of mega-mergers such as Sears and Kmart, and the role REITs may play in these ventures. Dale Anne Reiss, 212.773.4500; Mark Smith, 212.773.7990.
Legislation: American Jobs and RE
The passage in October 2004 of the American Jobs Creation Act created several significant tax benefits for real estate owners, particularly REITs and foreign investors. Most important, the Act creates a level playing field for overseas investors in publicly traded U.S. REITs - a provision that is expected to increase investment in U.S. REITs by such investors. Among the other benefits for the real estate industry: a deduction of up to nine percent for qualified production activities income that benefits companies providing construction, engineering and architectural services; a 15-year recovery period for depreciation of qualified leasehold improvements; and relief from certain asset test violations for REITs. Bob Schachat, 202.327.8010; Mike Frankel, 214.969.0632; Dianne Umberger, 202.327.6625; Mark Fisher 202.327.6491.
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The views expressed in this article do not necessarily reflect the views of Ernst & Young LLP or Business Facilities.
© 2005 Ernst & Young LLP. Reprinted with permission.
