by Martin Sinderman

Real Estate Portfolio recently asked Peter E. Baccile, managing director, global head of JP Morgan Securities, Inc.’s Real Estate & Lodging Investment Banking Group, to share his thoughts on the capital markets for publicly traded real estate and the industry as a whole.

Portfolio: What’s your view on the state of today’s real estate capital markets?

Baccile: As we start out in 2002, I’d characterize the real estate capital markets as wide open, with high levels of investor interest across the board.

It’s interesting to look at this from a historical perspective. In 1998, when the collapse of the Russian ruble created a global liquidity crunch, there was absolutely no liquidity in the marketplace to support investing in real estate. This was at a time in the real estate cycle when occupancies and rents were increasing, there was limited speculative development and debt levels were conservative. In short, the underlying fundamentals of the real estate business were strong, but capital was scarce.

Today, the situation is completely the opposite. Occupancies and rents are falling in some markets. However, equity and debt capital are plentiful.

Portfolio: Why are real estate stocks attracting more investor interest?

Baccile: If, as many predict, we are heading into a prolonged period of low growth, low inflation and low interest rates where, almost by definition, it will be a lot tougher to make money, then higher yielding relatively stable investments such as real estate become very attractive.

As you look at other investment opportunities you find that bond yields are low and investors are no longer properly compensated in the equity market for high levels of volatility. The risk/reward tradeoff is out of balance.

Even with slightly deteriorating fundamentals, the risk/reward equation favors the yield characteristics of real estate. The real estate public equity markets offer on average a 7 percent or 8 percent current yield, with the potential for growth up to a 10 percent to 12 percent total return on a relatively predictable stream of cash flows.

Portfolio: Given that, what is your outlook for the real estate investment marketplace for the remainder of the year?

Baccile: I generally feel that things are going to pick up in the second half of the year. However, I also think it is going to be 2003 before people begin to feel really confident again about the economy.

If interest rates and inflation stay low, and economic growth remains slow—and I do not think these are particularly big “ifs”—then it is going to be hard to make money in general. And I think that will help attract capital flow to real estate for the reasons I’ve touched on previously.

Portfolio: How do you see 2002 unfolding for the various property sectors?

Baccile: Investors are trying to make the distinction between what is currently overbought vs. oversold. Against this backdrop, I would tend to think that multifamily will do well. Historically in times of economic stress the multifamily sector comes back very quickly when the economy turns.

I expect neighborhood shopping centers—grocery and other necessity-anchored centers—to do very well. I’m not so certain about regional malls, but the regional mall has been mistakenly taken for dead several times in the past and has proven resilient.

The office sector is interesting due in part to recent consolidation. Now that Equity Office Properties Trust is part of the S&P 500, it’s even more of a “must-own” stock. Overall, though, I don’t know if there is a lot of upside in office over the near term. In my opinion, if you are investing for return, you might not want to go there right now.

The industrial sector has undergone similar consolidation. We recently finished working on the sale of the Cabot Industrial Trust portfolio to CalWest, a venture between CalPERS and RREEF, effectively taking them out of the public market. I look for the industrial sector to continue to do well and attract capital.

Portfolio: One sector that has struggled of late is lodging. What is your outlook for that market in the coming year?

Baccile: In thinking about 2002 and 2003, the lodging sector is the one sector that is operating with the least visibility. Most investors have yet to develop a view and are, therefore, continuing to sit on the sidelines, and will remain there until they believe the sector has hit bottom. Significant capital flowed out of this sector in the fall of 2001, but I think there will be some great opportunities in the lodging sector in 2002.

Portfolio: What kind of real estate investment opportunities do you see outside the U.S.?

Baccile: The major opportunities are in Europe, as investors seek to capitalize upon the transfer of assets from corporate to private ownership. Primarily on the continent, you are seeing billions of dollars worth of property changing hands, as major European telecommunications companies, banks, some state-owned railroads and transportation companies sell their real estate and lease it back, taking the capital out of the property and putting it back into their core business. There has been an awful lot of money raised by stateside real estate financial sponsors to invest in this transformation. The game is clearly one of buying wholesale and selling retail. The arbitrage profits can be significant.

Portfolio: We’ve touched on the impact the economy will have on the industry, but what other major challenges do you see facing the real estate industry this year?

Baccile: One major challenge will be the issue of terrorism insurance. The events of September 11 had a large impact on the insurance companies and their assessment of the risk of terrorism.

In the past, all of the investment capital put to work in this country has gone toward growing the economic pie; now we have to spend money to protect the pie. I worry that a huge amount of capital is going to go into assessing and managing the security risks we now perceive, which will make it seem a little like we’re running in place for awhile.

To date, the insurance industry has addressed the problem by significantly increasing both deductibles and premiums. In the process it has become almost completely uneconomical for property owners to maintain terrorism insurance. Perhaps this is an overreaction, but we won’t know for sure until we have a better handle on what the new status quo will be for security and terrorism in the U.S.

The rating agencies, including Standard & Poor’s and Moody’s Investors Service, have recently said that they are indeed going to require terrorism insurance before they give AAA ratings to securities backed by properties. The banks and insurance companies have yet to determine how they will respond to the need for terrorism insurance, but will likely require it as well. This, of course, raises the question of whether a lack of terrorism insurance is going to make it impossible for owners to finance their properties.

Some kind of government solution may be necessary. But, we really don’t know how the government is going to step in, if at all. There are a lot of unanswered questions that members of the real estate, insurance, securities rating agencies, and governmental entities are going to have to work out.