By Christopher M. Wright

Name: Lawrence Gray Title: Managing Director, Head of Real Estate Corporate Finance at Wachovia Securities Age: 38 Experience: Gray has 15 years of experience in the real estate industry, mostly in investment banking but also in property level leasing and research. He has been in his current position for more than five years.

Real Estate Portfolio recently asked Lawrence Gray, managing director, head of Real Estate Corporate Finance at Wachovia Securities, to share his thoughts on the capital markets for publicly traded real estate and the economy as a whole. [Editor's Note: This interview was conducted before the war with Iraq began.]

Portfolio: What do you expect from the market for the next 12 months?
Gray: I'm cautiously optimistic about the rest of 2003. I think the economy will begin to improve at the end of the year or early next year as we work through several issues overhanging the market. Namely, the situation in Iraq, overcapacity and limited to no pricing power among manufacturers, and the significant lack of risk and expansion capital investment by business.

Although we are not in a classically defined recession, the modest level of GDP growth we are currently experiencing is not high enough to generate new jobs—one of the key ingredients needed to help many of the real estate property sectors. Many economists, including our own, say GDP growth of 3.5 percent is required to create new jobs given recent productivity gains from technology, and that's 25 basis points above the historical average. I would anticipate several 4.0 to 4.5 percent quarters over the next couple of years. That will certainly help fill some office space and apartment units.

Portfolio: Many analysts have commented that the lack of capital spending by businesses is holding the economy back. When do you expect capital spending to improve?
Gray: The uncertainty—about Iraq, North Korea, consumer debt, the budget deficit, and corporate malfeasance—is killing business investment. These global and economic uncertainties combined with the fact that the risk profile of the average CEO in a post-Enron/Sarbanes-Oxley world is more cautious now than it has historically been has virtually shut down significant capital expenditure projects. CEOs are loath to undertake significant capital expenditures in an environment where there is no visibility regarding the future.

Portfolio: What does all this mean for real estate?
Gray: We have had a strange dynamic going on with REIT stock performance versus the real estate operating environment. Over the past three years, REIT stocks outperformed the market despite one of the most challenging operating environment seen in quite a while. The exact opposite was true in 1998 and 1999—fundamentals were pretty strong but the relative performance of REIT stocks was very weak.

I expect property fundamentals to improve across all property types toward the end of the year when the economy picks up. But, ironically, the relative performance of REIT stocks will likely suffer as investors rotate out of slower growth, lower volatility stocks like REITs and into stocks with more of a growth orientation that will benefit from greater operating leverage in an economic recovery.

Portfolio: Do you expect mergers and acquisitions to increase?
Gray: There are several trends favoring increased strategic M&A activity. First, there has been a shift in CEO mindsets. The original CEOs of most REITs made their personal fortunes eight to 10 years ago when they took their companies public. They are starting to turn over the reins to other talented managers who are finding it tough to create value for themselves in the REIT structure. Fortunes are created at capital events, so this new breed of CEO is likely to be more willing to entertain merger/sale discussions where he or she may not end up running the new company. Second, boards should become more active and demanding of management given heightened scrutiny in a post-Enron world with the passage of Sarbanes-Oxley. Combine that with the desire of boards and management teams to avoid the kind of negative publicity that comes from any type of structural or perceived conflict being aired out in public, and I believe many will be more receptive to private "bear hug" approaches.

Portfolio: How would you size up the real estate debt markets at the moment?
Gray: The real estate debt markets are extremely active given the current rate environment and the continued expansion of the CMBS and unsecured debt market. CMBS originations are fairly steady despite the refinancing trough we are currently in. Also, the unsecured debt market was very active in 2002. There was $12 billion of unsecured REIT debt issued in 2002, compared to $9.5 billion the year before. This volume was driven by many factors including low Treasury rates, tightening spreads as investors gravitated toward REITs vs. corporates, and, to a lesser extent, the positive arbitrage of taking out callable preferred stock and refinancing with debt.

Several companies in 2002 called in preferred stock that was issued five or more years ago at rates of 8.5 to 9 percent and issued five to 10 year unsecured debt at 6 to 7 percent. That 150 to 300 basis points of savings on the liability side is pretty compelling to many companies who are seeing falling rents, higher concessions, tenant bankruptcies, etcetera on the asset side.

Another big positive was the expansion of the investor base in the REIT debt market. While CBO and CDO sponsors [collateralized bond and debt obligations] were significant players on the buy side at the end of 2001and beginning of 2002, the bulk of issuance last year was placed with more traditional fixed income investors, many of whom were getting into REITs for the first time. This expansion of the investor base is extremely positive for the market and will be critical in keeping spreads attractive as we enter an increasing wave of refinancing from the REIT bonds issued seven to 10 years ago.