Winter 2000
	Cover Story REITs at the Millennium Industry veterans look into their crystal balls. Where are REITs headed? Company Spotlight Can Crescent Get Its Groove Back? John Goff is working to restore Crescent Real Estate Equities’ reputation as a REIT that "gets it." Property Fundamentals Lack of Correlation J.P. Morgan’s Michael Giliberto provides answers to the age-old question, "Are REITs really real estate?" Awards Spotlight Best & Brightest Realty Stock Review’s eighth annual awards presentation recognized the top vote getters in a number of categories, including outstanding analysts, CEOs, and CFOs. Voters also chose the industry’s man of the year and men of the decade. Investment Analysis Applying MPT to REIT Portfolios Careful portfolio construction can make or break the performance of a pool of assets. Investment Fundamentals The High Cost of Real Estate Ownership Swapping net income for FFO might not be such a bad idea after all. By The Numbers A Fund Manager’s Worst Nightmare If it’s true that what doesn’t kill you makes you stronger, real estate fund managers may be some of the strongest folks around. Point Of View REITs and Rights Plans Criticism of REITs that adopt rights plans is simply misplaced. Investment Spotlight Spooked What happens when more than a dozen REIT UITs start unwinding in the midst of the worst bear market in a quarter of a century? The New Economy When Worlds Collide The Internet will provide investment opportunities for innovative office and retail real estate companies that embrace the changing landcape. Investment Insight LBO Math The market is beginning to understand that LBO valuation does not equal net asset value. Parting Shot Coming of Age REITs have evolved from pools of properties to focused real estate operating companies. Newsline Captec Wants to Shed REIT Status Investor's Guide Questions Back Issues Feedback

By Joseph M. Harvey, Steven R. Brown, James S. Corl, and Sheila M. Stoltz
Illustration by Brian Rea

The Internet will change our lives perhaps as significantly as lives were changed by the Industrial Revolution. To understand why you need only to look at the numbers. At the end of 1998, there were 92 million Internet users; this number is expected to grow at an annual rate of 28 percent through 2003. Moreover, Internet penetration is expected to reach 65 percent of all U.S. workers and 50 percent of all U.S. households by 2003. If baby boomers are a "touch and feel" generation, the echo baby boom may emerge as a "click and see" generation.

The Internet will influence real estate values positively and negatively. The most important Internet factor influencing valuation will be the impact on demand for real estate, which may stem from macroeconomic factors or from distribution "channel shifts" - the change in commerce distribution driven by the Internet. Another major factor influencing property values is the opportunity to create new income streams, which will result in higher growth rates for certain property types.

The Internet’s Impact on the Office Sector
Just as the productivity benefits of the Industrial Revolution in the early 19th century precipitated a shift from agrarian economies to manufacturing economies, the information technology revolution is accelerating the postwar shift in the United States from a manufacturing-based economy to a service and knowledge-based economy. As technology renders many low-skilled jobs obsolete, it simultaneously creates more opportunities for the highly skilled.

The Bureau of Labor Statistics projects that employment in information technology-producing fields, defined as industries intensive in their use of information technology, will grow from 44 percent of the private work force in 1989 to 49 percent in 2006. This shift will increase the number of information-based workers from 46 million in 1996 to 56 million in 2006. This represents a compound annual growth rate of 2 percent, compared with overall private sector employment growth of just over 1 percent.

Not surprisingly, the industries identified as intensive users of information technology are largely office-using employment sectors, including wholesale trade, finance, insurance, real estate, business services, software, and technology services. Accordingly, demand for office space will be driven by these fast-growing employment sectors.

The growth in demand for office space, spurred by this shift in economic makeup and work force composition, will not be uniform, however. Increasingly, a disproportionate number of skilled, knowledgeable workers are congregated in a few metropolitan areas - areas with amenities and a quality of life that attracts these workers. Knowledge-based companies, especially smaller ones that, incidentally, are driving the majority of job growth, are finding that they must locate facilities in these desirable and, increasingly, more expensive areas in order to access the talent pool that their businesses require. The expanding gap between the productivity of skilled and unskilled workers is increasingly driving the employers of skilled workers to locate in high-cost locations irrespective of occupancy costs, which have minimal consequence to these companies’ cost structures. Silicon Valley in California and Silicon Alley in New York City are only the two most obvious examples of markets where the need to access expensive, highly specialized employees has resulted in robust demand for office space and sky-high office rents.

There are several potential drawbacks to these trends. Some of the job growth, stemming from the most turbo-charged information technology-producing sectors, may prove to be somewhat volatile, rising and falling at least to some extent with fluctuations in the stock prices of companies in these sectors. Many office landlords in high-technology property markets have quite rationally either refused to lease space to, or extracted extraordinary terms from, companies with a lack of cash flow or an unproven business model. Internet-induced channel shifts also may result in credit deterioration among office-using industry groups which, although not related to technology production, are affected by it nonetheless.

Another consideration is that demand could ultimately be dampened by increases in telecommuting. Many industry experts had previously sounded the death knell for office buildings due to the phenomenon of telecommuting. This clearly has not come to pass as office absorption in the 1990s has been robust. However, the average square footage of office space per employee has declined 11 percent since 1992. This is attributable in large part to the usual cyclical economizing by office-using firms as rental rates rise. However, some portion also is attributable to the trend, prevalent among technology firms, toward open office environments that are typically more economical in space usage. Finally, some of the shift away from office space consumption presumably is the result of technological advances that have made telecommuting and hoteling more feasible.

The reverberations from these trends will be felt disproportionately in commodity office markets, the labor forces of which are characterized by lower education levels and lower productivity. Just as employers will pay a premium to be in a specialized location where they can access high-value-added workers, firms looking to fill lower skilled job requirements have many choices and will compete on price. They will migrate to areas where real estate costs are low and will stay low, where office rents are cheap, land is plentiful, and the average wage earner can afford to buy an average-priced home. Office rents in these locations are by definition low, but as technology destroys the low productivity jobs that are typically housed in these locations, the dampening of demand will most likely keep rents low.

The greatest incremental revenue opportunity available in the real estate world today is to participate in the tenant’s desire for enhanced high-speed telecommunication services. The new age telecommunications companies that provide these services estimate that the revenue opportunity is on the order of $5 per square foot of office space annually. Current economics to the landlord include revenue participation approximating 5 to 7 percent. In addition, some landlords have received equity participation in the telecommunication provider. The risk intrinsic in this trend is that as these enhanced data services evolve from being a rare amenity today to a necessary commodity tomorrow, the landlord who fails to stay current with state-of-the-art telecommunication services will be hopelessly out of date.

Due to the explosion in demand for bandwidth among business users, a new species of telecommunications company has been created to build in-building networks that provide high-speed Internet access within office buildings. The proverbial "last mile," control of which has proven so important in the residential market, is owned and controlled by the office landlord in a commercial office building. To exploit this position, landlords have turned to three new companies that have been formed to meet this need: OnSite Access, Allied Riser Commun-ications, and Broadband Office. All of these companies were formed by, or through relationships with, major office REITs.

Each of these three telecommunications companies will be "wiring" and selling services to over 300 million square feet of office building tenants. In total, this represents over 900 million square feet, which is over 20 percent of all commercial office space in the United States. With over four billion square feet of office space in the United States and an estimated revenue potential per square foot per year of approximately $5, the resulting $20 billion market is enormous. Not surprisingly, the value creation potential for the office landlord is significant. Almost all of the major office companies - public REITs in particular - have received equity participation in these three companies as consideration for signing agreements to provide access to their building "pipe" and tenants. Each of these three companies is expected to have multibillion dollar market capitalizations.

The Impact of E-commerce on Real Estate
Retail real estate is the property sector that is expected to be the most negatively impacted by the Internet. However, the impact will vary dramatically, with factory outlets suffering the most and regional malls suffering the least.

The Internet and the rise of e-commerce will have a profound impact on retailing and retail real estate. The number of online shoppers is expected to rise from 20 million to 80 million by 2003, and online shopping is expected to increase from $8 billion in 1998 to $75 billion by 2003, which would equate to 3 percent of non-auto retail sales. The dramatic growth in e-commerce will come at the expense of all existing distribution channels, including regional malls, power centers, community centers, and factory outlets, as well as catalog merchants.

The number of e-commerce retail sites and the breadth of products offered grow almost daily. Leading products sold over the Internet include computer hardware and software (30 percent), airline tickets and hotel rooms (30 percent), books (5 percent), and gifts (5 percent). There has been an avalanche of Internet retailers formed in the last 24 months, and growth capital has been cheap and plentiful. Additionally, many traditional bricks-and-mortar retailers have begun to aggressively pursue e-commerce. Approximately 40 percent of the leading public retailers now have full-scale e-commerce sites. The consumer has been a major beneficiary of this new marketplace, because many online merchants practice loss-leader pricing and e-commerce currently enjoys a sales tax moratorium.

Regional Mall Tenant Composition Category In-Line Space Share of Internet Threat Apparel 35% Low Shoes 10% Low Food 9% Low Theater/Entertainment 7% Low Stationery/Cards/Gifts 7% Moderate Services 6% Low Home Entertainment 5% Low Books/Beauty/Health/Drug 5% High Sports/Toys/Hobby 5% High Furniture 3% Low Jewelry 3% Moderate Other/Specialized 5% Low Sources: International Council of Shopping Centers, Cohen & Steers Capital

The attributes of e-commerce, such as 24-hour access, broad product availability, and excellent product information, are powerful competitive advantages that threaten bricks-and-mortar real estate. However, traditional retailing also possesses certain advantages that include the ability to see and touch products, vendor relationships, and the utility of a store for returns and exchanges. Ultimately, the consumer will demand the benefits provided by the Internet and by physical stores. The result will be a "clicks and bricks" environment in which the consumer can transact interchangeably in all channels. Therefore, the most successful retailers will have coordinated Internet, catalog, and bricks-and-mortar strategies.

While every segment within the retail sector will be challenged by "e-tailing," the sales impact will vary by product and distribution channel. The Internet will significantly impact commodity, low price-point, and efficiently shipped goods that are sold through generic, low-service, and minimal experience shopping channels. By contrast, the Internet will have minimal impact on unique or impulse purchases that are sold through channels that offer an enjoyable shopping experience with a high level of customer service and personalization.

As a result, the business of owning retail real estate will be negatively impacted by the Internet Revolution due to diminished sales growth and percentage rent, reduced demand (occupancy) for certain product/tenant categories, and higher cost of capital (risk premium).

Due to their apparel orientation, class A regional malls should suffer the least from the growth in e-commerce. In addition, their high level of sales productivity will continue to attract the newest and most productive retailing concepts. Many retailers will use these dominant locations as showrooms for their product offerings. In addition, as successful Internet retailers grow they will open mall-based stores to enhance brand awareness. The locational attribute of class A malls, specifically proximity to population density and disposable income, is a critical factor that will support real estate values. In addition, many malls have evolved into local entertainment hubs with quality line-ups of dining, movies, and athletic venues. While the economic makeup of the mall will evolve over time, the mall should sustain its role as a community gathering place, fostering human interaction in the Internet Age. Operators of class B and class C malls, however, will need to proactively manage the market share decline for bricks-and-mortar retailers.

The typical product category allocation for a regional mall is heavily oriented toward apparel and shoes. These two categories comprise close to 50 percent of the nondepartment store selling space (see table at left). Apparel sales today are just a small component of Internet commerce at $300 million, or 3 percent of e-commerce. One hurdle for apparel e-commerce is the high cost of product returns, which approximate 30 percent. Product categories that have sold well via the Internet - toys, books, and gifts - comprise only about 15 percent of mall selling space. A likely outcome of the continued explosive growth in e-commerce sales would be a reduction in the number of tenants that offer these products within the mall. While not catastrophic, this will temper maximum occupancy levels as well as percentage rent growth over the long term. Our best estimate for the decline in comparative store sales at regional malls is 0.5 percent per year, which compares to trendline gross sales growth of 4 to 5 percent annually.

Management
Growth in apparel sales over the Internet is likely to come at the expense of direct or catalog merchants. While e-commerce history with apparel is brief and limited, apparel has been sold via catalogs for decades. Consumers who purchase clothing and shoes via catalogs are likely to consider the Internet. Catalog shoppers, therefore, represent a good estimate of the size of the market that prefers to purchase apparel without trying it on. The catalog apparel market, approximately $20 billion or 7.2 percent of all apparel sales, has been growing at an 8 percent annual rate.

Not surprisingly, the leading online apparel merchants are predominantly catalog-oriented companies such as Lands’ End, L.L. Bean, J. Crew, and Victoria’s Secret. Their "first-mover" status and customer base have led to early e-commerce leadership.

Online Market Share Category 2003 Share Projected Retail Format Impacted Computer Software 35.5% Power Center Books 11.3% Power Center Music 9.2% Power Center Video 5.9% Community Center Home and Beauty 2.6% Community Center Toys 2.0% Power Center Consumer Electronics 1.8% Power Center Apparel and Accessories 1.6% Regional Mall Grocers 0.7% Community Center Sources: Jupiter Communications, Cohen & Steers Capital Management

For the time being, community centers that are anchored by grocery and drug stores are expected to co-exist with the Internet due to: (1) distribution and logistics challenges associated with perishable goods; (2) urgency of necessity items, such as acute care medication; (3) the presence of personal-service-oriented tenants; and (4) the focus on low price-point items that have high relative shipping costs. However, some goods currently offered in the community center are vulnerable to the Internet because they are low price-point commodities that are repeatedly purchased (e.g., prescription drugs, toiletries, beauty aids). Therefore, the vulnerability of the community center will bear a direct relationship to improvements in distribution and logistics efficiency.

The logistics of delivering perishable goods cost-effectively to consumers’ homes is the most important hurdle to e-commerce penetration and, therefore, community center vulnerability. This should limit the impact of the Internet on bricks-and-mortar sales in categories such as frozen foods and fresh produce in the near term. However, online grocers, such as Peapod and Webvan, have raised significant amounts of capital and will spend that capital to attract consumers and to refine the "last mile" of the distribution system. If a cost effective infrastructure for the last mile can be established, the community center will become increasingly vulnerable to the Internet.

The Internet is already well suited for the distribution of goods sold in the power center. The power center "commoditized" many higher price- point categories, such as electronics, office supplies, and sporting goods, thereby providing the consumer with low costs and broad selection in one retail venue. Projected e-commerce penetration of 10 percent or more in each of the books, software, and hardware categories reflects meaningful potential channel shift.

Over time the Internet will reduce the number of trips to both the community center and the power center. Reduced traffic and cross-selling opportunities will place downward pressure on the long-term growth rates for these shopping center formats.

The potential for retail landlords to increase revenue from Internet-driven innovations appears to be limited. Nonetheless, landlords have to understand and integrate e-commerce as best as possible. First, all bricks-and-mortar retail must increasingly focus on providing a high-quality shopping experience that attracts people not only for the product but also for the experience. Second, bricks-and-mortar retail needs to fulfill a community aspect that draws people and encourages interaction. Third, retailers need to focus on customer service and satisfaction.

Some regional mall owners are using their franchises and scale to capitalize on the Internet. Business opportunities include telecommunications, advertising, and personalized shopping. Owners of mall portfolios are beginning to offer broadband Internet access to tenants, similar to the initiatives in the office sector. Kiosks designed for electronic advertising have been installed in some properties, and demand from Internet companies has been quite high due to a mall company’s heavy visitor count and national reach. Some mall owners have begun to offer personalized shopping technology, which enables the customer to input purchases as they tour the mall. The customer can charge the purchase without using a register, and this service gives the customer the option of pick-up or home delivery, as well as delivery of out-of-stock items.

Bottom Line Impact
Because the Internet centralizes activity while being physically decentralized, it represents a potential threat to all commercial real estate and will challenge real estate management teams. Nevertheless, the consumer wants the benefits provided by both the Internet and by bricks-and-mortar channels. For that reason, some real estate companies will successfully position themselves to operate in an environment where the virtual and the real estate worlds - "clicks and bricks" - interact with one another.

Editor’s Note: In the course of preparing this article, Cohen & Steers relied on several research firms and data sources, including Jupiter Communications, Deutsche Bank Alex. Brown, Merrill Lynch & Co., Forrester Research, and PricewaterhouseCoopers.

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