It is a challenge to speak to you today about outlook for U.S. real estate markets. The present situation is dominated by paradoxical conditions, both in the economy in general and in real estate markets.

The first paradox concerns the health of the general U.S. economy.

In many respects, the U.S. economy is doing well. Real gross domestic product rose at an annual level of 3.1% in the second quarter and 7.2% in the third. Stocks reversed their huge declines in 2001 and 2002 and have made a substantial upward movement.

In 2002, the NASDAQ composite fell 32.3% and the S & P 500 dropped 23.8%. In 2003 up to November 13, 2003, the NASDAQ was up 46.8%, the S & P was up 20.3% and the Dow-Jones Industrial index was up 17.9%. Of course, all three are still far below their highs in 2000. The NAREIT equity index was up 30.6%.

Single-family housing is still very strong, with existing sales in July at a record annual rate of 6.12 million and new sales at a 1.16 million rate. New housing starts were running at an annual rate of 1.8 million, not counting mobile homes. The median price of existing home sold was 12.1% above one year earlier.

In real terms, personal consumption expenditures in the second quarter were up 2.9% over one year earlier and 6.0% over two years earlier. Corporate profits in current dollars in the second quarter of 2003 were 11% above their low point in the fourth quarter of 2001, though slightly lower than in the first quarter of 2003.

The effects of various stimulative policies are now appearing. These stimuli include substantial income tax cuts, high defense spending, and very low interest rates held down by the Federal Reserve's highly accommodative policies.

On the other hand, significant elements of the economy are not doing well at all.

Non-residential private investment in the second quarter of 2003 was still below its levels in all of 2001 and 11% below its peak in 2000. Businesses have just begun to resume spending on plant and equipment because capacity usage is still low. Recently, the Wall Street Journal said capacity usage was improving, but only because excess capacity had stopped growing larger - not begun shrinking.

Whole industrial sectors are still in terrible shape, including airlines, much of manufacturing, iron and steel, apparel, and resorts and tourism. Air travel seems to be improving because the airlines have grounded over 1,000 planes, so the ones they are still flying appear to be much better occupied. But office and industrial markets are still heavily overloaded with vacancies, though tenant visits have started picking up and rents have hit bottom in most markets.

The most publicized deficiencies are in job recovery. Though unemployment fell slightly to 6.0% in October, the number of non-farm jobs was shrinking until September and October, when it rose by over 100,000 each month. Real GDP fell for just 10 months to its low point in September 2001, just after 9/11. We are now 25 months past that GDP low point, with GDP steadily rising.

In the 1991 recession, real GDP also fell for 10 months, but jobs kept falling 18 months after their high point in July 1990. The total decline in jobs from high to low was 2.5% or 2.8 million. Then jobs started rising. After 30 months from the job high point - where we are now - jobs had been rising for 10 months but were still 1.4% under their previous high.

In this recession, jobs started falling after their high point in March 2001. In September, they were 2.1% below that high. We lost 2.8 million non-farm jobs, but jobs have been rising for 3 months. At this point in the 1991 cycle, jobs had been rising 11 months. Yet in percentage terms, jobs have not yet fallen as far as they did in 1991, but they fell for a longer period.

When you look at this comparison in this detail, we do not seem all that much worse off than we were in the previous recession. We lost the same number of jobs to the low point in absolute numbers, but in percentage terms we lost fewer. Jobs always recover more slowly than GDP, and they are a bit slower than usual this time.

All of our net job losses have been in manufacturing. From peaking in 1998 to September, manufacturing jobs fell by 4.2 million - 23%. In fact, from the peak of total jobs in March 2001 to September 2003, non-manufacturing jobs actually rose by 768,000, or 0.67%. But this is nothing new - the U.S. economy has been losing manufacturing jobs in absolute terms since 1979 - 24 years ago. They fell by 2.2 million jobs, or 10.7%, from 1979 to 1998, and another 23% since then. This was due to rising productivity in manufacturing and the evolution of our economy from goods to services. We also lost tons of farm jobs earlier in our history when we shifted from farming to factories, but our total agricultural output keep right on rising, as has manufacturing's output.

True, many manufacturing jobs have moved overseas, and many service jobs are doing so as well. When I phone for computer support, I talk to people in the Philippines and India. Many of these jobs will not come back. But if we allow currencies to float, this export of jobs will cause workers overseas to get wealthier and buy more of what we produce - including farm outputs. I do not believe such globalization is ruining our economy or should cease.

The big challenge in this evolution of employment is that we must raise the educational level of our workforce to take on future high-tech jobs. Right now, we are importing millions of immigrants with low-level educations and failing to train our poor urban populations to meet future job needs. That is the true challenge of globalization to the U.S. economy and society, and it is a challenge to which we are not effectively responding.

The upshot of this paradoxical situation is that the U.S. economy will continue to expand through 2003 and 2004 and probably longer. Jobs will soon start increasing again, though not as fast as many would like. The stimuli to our economy of continued consumer wealth, rising stock prices, heavy defense and foreign spending, and low interest rates will soon start more investment spending as well. Even some lagging sectors may recover, though many high-tech stocks are already far outrunning reality.

This overall growth results in part from a gradual recovery from the great general uncertainty about the future that plagued the economy after 9/11. The quick end of the intense combat part of the Iraq war removed much of that uncertainty, though we are going to have to stick it out there at great costs for many years. And we still face great uncertainties in North Korea, Iran, and Afghanistan.

But unfortunately for people in real estate, the one depressed sector of the economy likely to recover most slowly is commercial real estate.

So let us now talk about where we are in the U.S. real estate cycle. I believe the commercial real estate cycle has three phases, which follow one another in regular order.

The development boom phase starts at the top of a general business cycle expansion. Strong demands for space cause space markets to exhibit low vacancy, rising rents, and rising property values. So developers start building lots of new buildings. The most recent development boom was from about 1997 to 2000.

Just as a lot of this space comes onto markets, the general economy goes into a recession, and space demands stop growing and often shrink. This generates the overbuilt phase in which vacancies rise, rents fall, property prices normally fall, and no new building is started. The present overbuilt phase began in 2000.

This overbuilt phase is not quite as bad as the one in 1990. Why not? Because this one was not caused so much by massive new building as in the late 1980s, as by a sudden shrinkage in demand - mainly for office space - when the internet bubble burst. The overall office vacancy rate in mid-2003 for 2.8 billion square feet of space in 28 downtowns and 24 outlying areas in North America as reported by GVA was 16.2%. Vacancy was 14.7% downtown and 17.4% outlying, with negative absorption outlying.

The overall industrial vacancy rate in 45 markets as reported by CB Richard Ellis in the second quarter of 2003 was 11.6%, up from 11.2% one year earlier. Twelve regions had over 15% industrial vacancy. New construction rose 39% in the 2nd Q vs. the 1st Q, but was 62% below the 2nd Q of 2000.

Both markets are plagued by tons of space firms are trying to sublease, plus even more they are holding unused. All that unreported space must be absorbed before there can be any significant decline in reported vacancies.

Retail space is not as overbuilt in spite of the fact that so much added such space has been created. One reason is that much of the new building was the introduction of new technologies - the power center and giant discounters. Hence the surplus is concentrated in older, more obsolete outlets of all types.

The question is: when will the overbuilt phase end, and the next phase - the gradual absorption phase - begin? That phase takes place when the general economy is growing faster, so space market conditions begin to get better. Vacancies decline, rents stabilize or even rise, prices stabilize, but these conditions lag behind the growth of the general economy. So rents aren't yet high enough to stimulate new building.

In the early 1990s, the overbuilt phase lasted 3-4 years, and then the gradual absorption phase also lasted 3-4 years - both unusually long. The development boom phase of the late 1990s began about 1997 and lasted three years.

I believe the current overbuilt phase - which began in 2000 - will last through 2003, and then transform into the gradual absorption phase as space markets start to soak up their present high vacancy levels - including space for subleasing or just not being used. I do not expect much office space prosperity - or new development - in 2004. But vacancies will start falling and rents will stabilize. The same forecast applies to industrial.

These projections indicate that the next development boom phase will not start before 2005, and that would be early. If the gradual absorption phase lasts 2.5 years, the next boom would not arrive before mid-2006. True, the future can always surprise us.

One implication of this analysis is that property management should receive primary attention from all property owners. This means tight expense control, proper investment in capital improvements, and no skimping on promotion of new business. In periods of stress, conservative debt financing and great staying power are crucial.

Now I would like to discuss a paradox in commercial property markets that emerged in 2002. The market prices of many commercial properties have remained strong in spite of basically deteriorating conditions in space markets.

Basic conditions in commercial space markets badly deteriorated in 2001 and 2002. Yet whenever a well-occupied commercial property with few leases turning over soon has come on the market, there have been many eager buyers bidding for it. As a result, the prices of such properties have not declined along with underlying conditions.

One sign of this paradox is that prices of REIT shares have moved in the opposite direction from prices of most stocks. From the end of 1999 to April 2002, when the major stock indices all plunged, the NAREIT equity REIT index rose 77.7%. In 2002, the NAREIT index rose 3.8%, and it has risen 26% more since Jan. 1, 2003.

Why should property prices on well-occupied properties be rising when the outlook in space markets is bad and getting worse? The answer is that investors believed both current yields and future prospects for well-occupied real properties were superior to those in major alternative types of assets - namely stocks and bonds. Many cash-laden, yield-hungry investors were under pressure to do something with their money that would produce better yields than stocks and bonds seemed likely to exhibit soon.

Low mortgage interest rates help stimulate property buyer demands. Hence in late 2002 and 2003, many more transactions were completed than in 2001. But transaction levels are still well below those typical in similar parts of past cycles. That is a result of remaining uncertainty about all future asset yields.

In the stock market, though the major indexes have risen from their low points after the 9-11 attack, they are still way below their peaks in early 2000. Yet some experts think many tech stocks are overvalued because of high P/E ratios.

In contrast to stocks and bonds, highly-occupied real estate promises much higher current income, plus better appreciation prospects than alternative assets. REIT dividends in the 6-7% or higher range are better than most bonds and all other stocks. Also, investors expect lower yields due to lower interest rates.

This situation should prove once and for all that real estate is an asset class separate from stocks and bonds, and the values of real properties move in a cycle that differs in timing from the timing of stock and bond price movements. As a result, diversification of large asset accumulations by owning a lot of commercial property makes sense, though few pension funds have done it.

Another implication is that the attraction of any type of asset to investors is not based on its own absolute performance, but on its performance relative to the alternatives. If the alternatives look terrible, an asset class can look good even if its fundamentals are worsening. But when an asset class's fundamentals are great - as with commercial property from 1996-1998 - but the likely performance of other asset classes seems spectacular - as did internet and high-tech stocks then - the first asset class may be ignored by investors, as were REITs. This is a result of more completely integrating real estate capital markets and all other capital markets. Investors are no longer looking only at each type of asset in isolation from the other types.

However, the enthusiasm of most investors for commercial properties is limited to those that are well-occupied, preferably with good credit tenants who have leases that will not roll for a while. New and old properties with high vacancies are being avoided like Arthur Anderson auditors. It is hard to sell such properties at any price.

Thus, the counter-trend movement of property prices is confined to a sub-portion of the market. There is a bifurcated market between well-occupied properties in great demand on the one hand, and partly vacant properties hard to sell at all on the other. This is great for big space users. They can buy vacant buildings for extremely low prices or get very low rents from the owners.

True, some opportunity funds have begun buying poorly-occupied properties, since they could not get well-occupied ones at low enough prices to achieve the high yields they promise to their investors. But the risks involved are high too.

An important point is that entrepreneurial owners of older, relatively obsolete buildings with strong occupancy and yields should consider selling them now if they can still get good prices. The most difficult decision in most asset markets is knowing when to sell, and now may be the time. In some areas, it may be too late!

How long will this paradoxical situation concerning property values last? Two risk factors might end favorable pricing for even well-occupied properties.

The first risk is that space market conditions might become so bad investors become leery of buying even well-occupied properties with solid credit tenants. That is most likely if the economy fails to keep growing steadily, so space demands fall even lower. This risk is growing much smaller as time passes and the economy keeps expanding.

The second risk is that very strong economic growth might occur, causing a notable rise in general stock prices. If investors shifted capital away from real properties as yields on alternative assets rose, the upward pressure on property prices would fall, so such prices might drop. So might share prices of REIT stocks.

True, REIT shares and property prices may be topping out right now after their big run-up. However, for several reasons, I do not believe they will soon fall absolutely.

The general economy is recovering, but only slowly in jobs. I do not think corporate earnings will soar fast enough to stimulate a really sharp rally of stocks back to or beyond their previous highs. Yes, stocks have already rallied quite a bit from their lows. But P/E ratios are already awfully high on NASDAQ stocks.

Some economists believe interest rates will rise rapidly, undermining profits on real properties. But I think the Federal Reserve is committed to keeping short term rates low until after the 2004 election. Hence leveraging based upon relatively low rates will continue to support real estate profitability for some time.

If the economy recovers strongly, demands for space in property markets will improve, thus offsetting the loss of very low interest rates on profitability.

A big benefit of owning real estate is current income - vastly higher than that of bonds and non-real estate stocks. Corporations and financial institutions need current yields to meet their pension fund obligations. Also, millions of baby-boomers retiring in the next few years will want good current incomes. So they will still be attracted to REIT shares because of current income from dividends.

Though the internet bubble proves institutional investors are certainly not dominated by pure rationality, they may have learned some things from recent experience. One is the value of more diversified portfolios, including real properties. Also, I believe investors who have been badly burned by losses in one type of asset develop a bias against putting more money into that type until changed conditions demonstrate conclusively that they will not be burned again soon. That bias worked against real estate in the early 1990s, but it works against stocks now, especially with rising distrust of Wall Street's fairness to investors.

The final factor in this situation is the huge amount of money in the hands of investors who want to put it somewhere that will earn them some returns. Until other options emerge as superior to real estate, some cash-laden investors will stick with real properties.

For all these reasons, I believe there will be no "collapse" of commercial real property values and REIT share values in the near future, even though those values will not keep rising as fast as they have been.

Altogether, near-future prospects for good operating profits in commercial space markets seem very poor well into 2004. And prospects for renewed development seem even worse until after 2004 or even 2005 - even if the overall economy starts growing fast in 2004. My motto for people in real estate is: You didn't feel much glee - in two thousand three, and there won't be much more - til after two thousand four. Good luck.