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2003 Fall Members’ Meeting Summary

This year’s Fall Members’ Meeting began with the Max M. Farash Real Estate Roundtable, an enlightening and inspirational evening for Research Sponsors, Executive Committee members, faculty, and special guests. The event was held at the Rittenhouse Hotel on Monday evening, October 20. Dr. William A. Galston, Professor at the School of Public Affairs, University of Maryland, and Director of the Institute for Philosophy and Public Policy was the guest dinner speaker. Professor Galston is the author of six books and nearly 100 articles dealing with political and moral philosophy, American politics, and public policy. He is currently the executive director of the National Commission on Civic Renewal. From January 1993 through May 1995, Galston served as Deputy Assistant to President Clinton for Domestic Policy, representing the White House in policy and legislative activities in the areas of education and children and families.

Galston was able to give the dinner attendees a unique perspective of domestic policy in the upcoming election. He observed that the budget deficit is soaring and entitlement programs are running a huge long-term imbalance. In addition, health care costs are rising at double-digit rates even as the number of uninsured Americans has reached 43 million and, the core of investment in human capital–the nation’s system of public education–is laboring under legislative reforms. Galston then focused on the central challenge of closing the achievement gap between white and minority students. He argued that if we are to have any chance of meeting this goal, we must not only fundamentally change the way we do business in our public schools, but also incorporate public education into a larger policy framework that addresses the crucial early years before children reach 1st grade.

The University of Pennsylvania’s Houston Hall was the venue for Tuesday’s Fall Members’ Meeting. Members who enrolled in our Career Mentor Program started the day early, meeting with students over breakfast. The real estate majors who have been paired with industry leaders enjoyed this unique opportunity to acquire insights gained from their Mentor’s professional experience. The Zell/Lurie Real Estate Center would like to take this opportunity to express sincere thanks to all members who have volunteered their time for this most worthwhile and much appreciated program.

John Bucksbaum, Chair of the Advisory Board of the Zell/Lurie Real Estate Center welcomed members, guests and students to the meeting. Joseph Gyourko, Center Director and Asuka Nakahara, Associate Director, then delivered a State of the Center address. Gyourko highlighted increases in resources dedicated to the Real Estate program at Wharton, including two new faculty slots, increased research productivity, and curriculum developments. Nakahara noted similar trends at the student level, drawing attention to increases in the number of real estate majors, club members and students with a real estate job focus.

The Meeting’s first panel, "The Crisis in the Hotel Sector: How to tell Opportunity from Wishful Thinking," provided valuable insights into the current and future state of the hotel sector. Panelists included and Dean Adler, Lubert-Adler Partners, John Z. Kukral, Blackstone Real Estate Advisors, Michael L. Leven, US Franchise Systems and Peter Weltchek, Banc of America Securities. Wharton Real Estate Professor Peter Linneman moderated the discussion and began by noting the challenges the hotel market has endured as of late: a weak U.S. economy, overbuilding, a weak foreign economy, September 11, SARS and the Iraq War.

Panelists all felt that the worst is over for the hotel sector. Peter Weltchek observed that real estate stocks are up 30-40% so far this year, reflecting the collective wisdom of many investors. Michael Leven said that the hotel sector cycle bottomed out six months ago in terms of operating performance. Dean Adler cautioned investors to be wary of several new, critical factors affecting the hotel industry. These include re-financings, technology, deferred maintenance, convention center supply and new terrorism. Adler also observed that the greatest number of hotel loans was made in 1999 and 2000, many of which become due in 2003 and 2004. It remains to be seen whether hotel owners will be able to meet these financing obligations. For the past several years, many hotel owners kept cash flows up by cutting capital expenditures, thereby creating a substantial pool of assets requiring significant investment.

John Kukral commented that one critical issue facing hotel investors today is valuation. From 1998 to 2001, during an up period, hotels had been priced similarly to traditional real estate assets. According to Kukral, however, if you are a hotel investor, "you now realize…you really do have volatility in these cash flows and shouldn’t be pricing them the way you are." One of Michael Leven’s chief concerns for the hotel business is room rate. A rebound in travel is not the worry, but price is. Leven noted that there are 17,000 travel websites, most of which have the inventories of the major chains. Wholesale sites cost hotels the most money (up to 35%) and although only 2-3% of rooms are booked online, the impact on rate can be large given the transparency of pricing. Despite these downward pressures on room rates, the hotel industry has managed in general to remain profitable.

Although the panelists discussed at some length many innovative issues in the hotel business such as the effects of technology, videoconferencing, internet price comparisons, etc., they all believed the basics of real estate would remain the key factors. Kukral said, "It comes back to real estate. If you have good real estate in a place where people want to be, you will get people to come." Speaking more generally on hotel investing in today’s market he advised against making cyclical bets but rather focusing on asset specific opportunities. Adler echoed this sentiment when he said that the critical ingredient to any successful hotel investment is having "superior management and superior ability to execute the business plan."

Despite the fact that not much hotel development is occurring, development is not dead. At least that was the general view of the "Development: Dead or Alive?" break-out session which included C. William Hosler, Catellus Development Corp., Ara Hovnanian, Hovnanian Enterprises and Stephen Lebovitz, CBL & Associates Properties, Inc. Asuka Nakahara, Associate Director, Zell/Lurie Real Estate Center, moderated the panel.

According to the panelists, several factors continue to drive development in the current environment. For retail development, big box retailers such as Wal-Mart and Home Depot have altered the landscape. According to Stephen Lebovitz, "Wal-Mart’s new development of retail space has dwarfed anything that our company and all of the other companies out there have done." This has changed the dynamic of the development business. Opportunities are in markets where existing retail space has become obsolete. Changing consumer tastes and demographics drive new development as customers go after value and convenience.

In the case of residential development, household growth has been the main driver. Ara Hovnanian commented that, "one of the good things about the housing industry is that over the long term demand is pretty predictable. Over the next three decades demand is projected to grow, on average, 1.5 million additional new households net, every single year. There is demand and it seems to be very steady." Nakahara questioned Hovnanian specifically about the differences with respect to the owner occupied market. Hovnanian responded that despite the recent recession, the Fed lowered rates quickly enough to support a buoyant housing market. The challenge now for homebuilders is providing supply. Hovnanian also noted, "The regulatory environment is getting more difficult and it is becoming increasingly hard to get new sites. With demand increasing every year we could sell three times the houses we are selling now but we can’t acquire the land." He pointed out that 10 years ago the public national builders supplied 10% of the market. Last year it was 24%. Hovnanian added that he would not be surprised if within the next 10 years the large public homebuilders account for up to 50% of the market. He also felt that this consolidation is good for the health of the housing market, as larger homebuilders with access to large amounts of resources, information and capital are more educated, make more market-driven decisions and benefit more from scale economies.

Nakahara then questioned the panelists on their current yield requirements. According to Lebovitz, yields have decreased on development projects due to increases in land values and construction costs. Rents have increased somewhat but not enough to offset these other factors. In the low interest rate environment, 10-12% seems to be the correct risk adjusted yield for retail development. For homebuilding, Hovnanian seeks a 30% internal rate of return, all in (pre-interest charge), but admits finding these yields are difficult. Hosler noted that location is not as important for industrial development, given only a need for highway access. He added that development yields are tracking 400 basis points over the 10 year, as interest rates have now become a key driver for industrial development.

Concurrent to the development panel was the panel entitled "Tenants—What Do They Want in This Environment and How Do You Keep Them?" Panelists included Michael D. Colacino, Julien J. Studley, Inc., William J. Hirschfeld, Cushman & Wakefield of Pennsylvania, Inc. and Roger S. Newman of Paramount Group, Inc. Julie Benezet, Principal, Business Growth Consulting and an Executive Committee Member of the Zell/Lurie Real Estate Center, moderated the panel.

Benezet asked the panelists what the key was to getting tenants to make deals. Colacino stressed the importance of helping clients match business plans with real estate needs, a task becoming increasingly difficult to do. When asked by Benezet what would keep tenants in buildings, Newman emphasized the importance of building a good relationship from the beginning and being reasonable, noting that turning over space is extremely expensive for a landlord. When pressed about the demands of tenants in today’s market Newman admitted that, "they ask for the world." Hirschfeld commented on the differences between today’s market and the downturn that took place in the early 1990s. Developers have refrained from overbuilding this time around. The market went very quickly from being strongly landlord-driven to tenant-driven due to a collapse in demand, not new supply. Tenants today are looking for everything, and they know they have buyer power. The paradox is that in markets where it would seem to make sense for a tenant to lock-in a long-term rate, they do not do so given the uncertainties in their own business. Newman predicted that tenant improvement allowances at $55 per square foot are not likely to increase much farther as both tenants and landlords have become more conservative with respect to the amounts and nature of improvements. He hinted that a prospective tenant could possibly secure a greater commitment from the would be landlord by sticking to improvements such as open landscaping, or anything that would be salvageable by the owner once the tenant moves out.

The Farash Distinguished Lecturer was Dr. Patrick T. Harker, Dean, The Wharton School, who provided excellent insights into "Education as a Service Business: Lessons from Others." Harker highlighted evolution in the service business and its relevance to higher education. He noted the trend of the 1980s was largely to "delight the customer." Businesses would keep customers happy at any cost. Although customer service levels were high under this model, they were unprofitable in some cases. In response to these trends, businesses resorted to identifying and getting rid of those customers who were "unprofitable," resulting in overall declines in customer service. The failure of "delighting the customer" and "firing the customer" led to a better philosophy Harker described as customer efficiency. "Customers not only have to be treated as recipients of the service, they have to be treated as part of the production process in delivering the service." According to Harker, the customer efficiency trend is effective for most service businesses, including higher education. Education is not about simply disseminating information to pupils, but rather, an interactive, hands-on process that emphasizes a "learner-centric" approach. Businesses and schools that fail to put systems in place to allow customers to deliver goods and services to themselves are doomed to fail. Making customers and students more efficient is key for any business to thrive.

Following Dr. Harker’s address, Professor Joseph Gyourko, Bucksbaum Professor of Real Estate & Finance at The Wharton School moderated a panel on "Return Compression in the Market and Its Effect on the Real Estate Industry." Panelists were Nori Gerardo Lietz, Pension Consulting Alliance, Douglas Shorenstein, The Shorenstein Company, L.L.P. and Hoke Slaughter, Morgan Stanley & Company, Inc.

Douglas Shorenstein took a straightforward approach to understanding real estate pricing in the current cycle. He divided assets into two categories. The first would be a stable, leased asset primarily used as a vehicle for levered yield generation by an investor. The second would have some sort of real estate exposure, most likely a leasing, construction or capital issue. It is the latter type, Shorenstein believed, that presents better opportunities, even in the current environment. Referring to the influx of capital in the real estate markets, Shorenstein pointed out "that capital is not buying real estate, it is buying yield." Key to this environment is to underwrite real estate fundamentals. Shorenstein would continue to look for Class A office buildings that would perform well from a leasing perspective, in down markets with 60% leverage. Shorenstein stated that successful investing "boils down to staying true to underwriting, staying focused on the real estate fundamentals and staying disciplined and intent on being in business for the long haul."

Nori Gerardo Lietz took the least optimistic view of the group. Lietz said, "I am telling our clients that it is a bubble." To back up her view, Lietz noted that rising vacancies have been coupled with falling incomes and falling cap rates. As capital continues to move into the sector, Lietz said, "People who are buying right now are essentially making a directional bet on interest rates." This is a strategy Lietz described as "extraordinarily risky" and would be better suited for a hedge fund of sorts. Lietz further stated, "Our advice frankly to our clients in the past 24 months has been to sell everything non-strategic." She felt that if and when yields do increase there would not be as much liquidity as people think.

Slaughter summed up the sentiments of many members of the real estate community when he stated that we are hoping for "the ‘Goldilocks’ economy. Not too hot so that people cycle out and not too cold so that the fundamentals don’t pick up in accordance with the economy…In one year’s time I wouldn’t be surprised at all if cap rates were 6 ½ % going to 8 %." Lietz noted that at "any movement in cap rates that is significant, the marginal increase in rental rates will be dwarfed by an upward adjustment in the cap rates."

The meeting ended with a reminder from John Bucksbaum to save the date for the Spring Members’ Meeting—April 22 & 23, 2004 at the Rittenhouse Hotel.

Posted November 2003

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