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In the years since the downturn of the late ‘80s and early ‘90s, real estate has been carrying investment portfolios. ING Real Estate’s US View reports that much of the industry’s strong performance in 2004 was “yield-driven as capital and liquidity remained at all-time high.” And the firm does not expect that capital flow to change over the next 18 to 24 months. “With so much capital weighing on the system, return performance is unlikely to slip significantly in 2005, although some additional yield compression could occur,” the report predicts. According to Will McIntosh, managing director, global and US head of research and strategy at ING Real Estate in New York City, the shift has finally opened investors’ eyes to the fact that real estate is a great diversifier–something the industry has been saying all along. But to be a player, knowledge is power and, to that end, McIntosh and his colleagues produce semi-annual reports on global and regional market conditions. In an exclusive interview, McIntosh–who was joined by Indraneel Karlekar, vice president, global research and strategy–spoke with GlobeSt.com about ING’s recent US View.

GlobeSt.com: Which property type seems to be taking over now in the private real estate market?

McIntosh: Fundamentals are improving across the board and the retail sector has clearly been leading the way. This past year alone the private market produced a 23% return, which is off the charts. Because of the favorable economic conditions and demographic trends, this performance is going to continue. Probably nothing like the 23% we saw in 2004, but we think there is still going to be strong performance over the next three to five years.

GlobeSt.com: How much has consumer spending added to the performance?

McIntosh: Even with interest rates sneaking up a little bit, such a large portion of our population is in their peak spending years, like the 46-to-54-age range. People are spending money to support their households and that’s helping to drive retail sales. That’s going to continue all the way out to 2010 when we expect that population to peak.

GlobeSt.com: How are the other property types doing?

McIntosh: The two that are picking up significantly are office and warehouse. The office market saw a significant uptick in the last two quarters of 2004. We see this as a strong cyclical rebound, specifically led by the creation of office jobs. We added another 131,000 new jobs this past year and we made up the job losses we saw in 2001, so we’re back up to where we need to be. Financial services should be stronger than most other sectors, and, because the general trend in our economy is moving away from manufacturing toward the service sectors, you would expect to see more jobs being created there. However, manufacturing came back a little too. That’s helping drive the industrial market, which is our next favorite property type. When we say industrial, what we really mean is warehouse, and that’s a different story.

GlobeSt.com: Like along the New Jersey Turnpike?

McIntosh: The New Jersey Turnpike, Exit 8A, between here and Philadelphia, is a fantastic market. Generalizing a little more than that, we’re focusing on the transshipment hubs, which are markets that are benefiting significantly from globalization, like Long Beach, Riverside [both in California], Seattle and Port Newark in New Jersey. You have imports and exports lining up and you need places to warehouse those shipments. That’s why the Northern New Jersey market is so strong. Miami is strong because it’s a hub for Central and South. There are a few others, but those markets tend to be favored because of there locations and the demand for space. The other side of that coin is that you have places like Detroit and Boston that have very large submarkets with weak economies that aren’t doing so well because the demand isn’t there. It’s perfectly logical, with all the global trade going on, that you would expect transshipment hubs to be doing better than the others.

GlobeSt.com: What about the capital markets?

McIntosh: Private real estate, overall, in 2004 had a 14.5% return–the very basic core real estate, which is the lowest risk, without leverage. This tends to be existing buildings with strong tenants, whether office, industrial or whatever. That return is well above what you would normally expect in the 7%-to-9% or 8%-to-10% range. The public real estate markets–REITs and REOCs–have done well. In 2004, REITs produced 31% returns. If you look at the past one, three and five years, real estate–whether in the public or private market–consistently outperformed the other asset classes like stocks and bonds. The S&P 500 had a 10.8% return and the Lehman Aggregate Bond Index, 4.3%. That’s on the one-year return, and the trend holds up for the three- and five-year returns. As a result, a lot of capital is flowing into real estate. Unfortunately for us on the private-market side, it’s caused us now to worry about pricing. With all this capital flowing in it’s tough to do a deal that we can be comfortable will produce the returns we’re looking for. We’re really sharpening our pencils and saying, “can we get to where we need to be and still be competitive?”

GlobeSt.com: Eventually, don’t those prices have to come down?

McIntosh: Real estate is a cyclical industry. But some people are arguing that it’s a new day because we’re in a low-interest rate environment and that may continue for a while. In this environment, the prices–which are much richer than we’ve been paying in the past–don’t look totally crazy because a big component of your return requirement is driven by interest-rate levels.

GlobeSt.com: What worries you the most?

McIntosh: Of the four food groups, the pricing for apartments has been off the charts. Looking at current market fundamentals we struggle with those prices because the apartment market is relatively soft. There’s a lot of supply out there and they’re still giving an average of a couple weeks rent concession on a 12-month lease. We think the market is 18 months away from being interesting again, although longer term the fundamentals will be attractive.

GlobeSt.com: As the stock market rebounds, is there a danger of that capital flow going away?

McIntosh: We think about that a lot. But, in our view, real estate has been accepted as its own asset class and it has a seat at the table with stocks and bonds. I don’t see pension funds, just because the stock market improves, doing a major reallocation. This recent downturn in the stock market has really opened their eyes to the true volatility of the stock market. It has helped institutional investors become more committed to real estate, not less. If a pension fund has increased its real estate allocation from 4% to 8%, they are having a hard time getting it invested right now because so many of the private investors with cheap debt have been borrowing to the max and competing for some of these properties. For us, as representing institutional investors, it’s a good thing if interest rates go up because some of these private investors will get out of the way. That’s not a bad thing.

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