Sule Aygoren Carranzais associate editor of Real Estate Forum magazine.

SAN DIEGO-The net-lease market for 2005 looks good, but there are some red flags to watch for. That was the consensus at Capital Lease Funding Inc.'s 10th Annual Correspondent Briefing, held this morning at the Mortgage Bankers Association's Commercial Real Estate Finance/Multifamily Housing Convention and Expo here.

According to William Pollert, president of CapLease, the economy will continue to improve gradually this year, although inflation will be "on everyone's radar screen." Additionally, the record current account deficit of $670 billion, among other issues, is a cause for concern. "While we can't put a specific number on the 'uglies' threatening the market, the point is there's a risk overhang that's greater today than ever before."

The real estate market will subsequently mimic the economic recovery. While fundamentals will continue to be relatively weak, Pollert said improvement will be confined to specific segments. Capital flows will continue to be strong due to a lack of attractive alternatives and a strong CMBS market of about $85 billion to $90 billion.

Hotels are experiencing a solid recovery, Pollert said, though it's "the one segment where property values seem to be lagging the recovery in fundamentals." Industrial, meanwhile, will be slow to bounce back, with vacancies around the 10.5% to 11% range. Office, too, is expected to be slow, with improvement uncertain and concentrated mainly around large urban centers.

Retail, which Pollert said never "missed a beat" in 2004, faces some challenges this year. Short-term sales growth is expected to slow, sales patterns are changing with the rising popularity of the Internet and gift cards and long-term demographics are deteriorating, as the 35- to 54-year-olds--the "big shoppers"--age. While the property type will continue to be hot, vacancies are expected to edge up to 8% this year, nationally.

Interestingly Pollert noted that consolidations and store closings will likely continue. And the underlying real estate values that have emerged due to mergers among big-name retailers, particularly Sears and Kmart, have "people questioning whether the retailers are worth more dead than alive."

The biggest red flag for real estate this year, Pollert said, is the perception among many in the industry that the fundamentals of real estate value have changed. While many feel that there's a "new paradigm" for real estate values, meaning that they will probably remain high since the asset class has earned a permanent spot in investor's portfolios, Pollert feels it's dangerous to think that way. "People said that about the technology sector, too."

The main question, he said, is "are investors in real estate because they believe fundamentals will recover and there's future value, or is real estate a temporary defensive investment?" In short, Pollert believes price tags for real estate are at or near their peaks, and short-term values will be defined by interest rate movements.

For the net-lease market, Pollert expects demand to continue to be strong, with supply growing by $25 to $27 billion due to the perceived peaking of values. While cap rates tightened another 50 to 60 basis points in 2004, with investment-grade properties trading at 5% to 5.8% and non-investment-grade caps in the 7% to 8.5% range, he anticipates cap rates to creep up in 2005. Tenant-in-common investors will also be tested this year, he noted, due to SEC rulings, high fees, unsophisticated investors and the realities of operating TICs. Pollert said they haven't been around long enough to have a set plan in case something goes wrong.

CapLease, a New York City-based REIT focused on financing and investing in single-tenant net-leased properties, filed a $240-million IPO in March 2004. According to CEO Paul H. McDowell, the firm raised the capital in order to "transition the business model from a 'gain on sale' lender to a full-service 'balance sheet' investors in all types of net-lease debt, equity and mezzanine financing. Today, the company has more than $335 million of loan assets on its balance sheet.

Instant Insights /

GlobeSt.com DISPATCH: CapLease Is Positive on Net-Lease Real Estate for 2005

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