It is a challenge to speak to you today about outlook for real estate markets, with emphasis on the United States, which I know best. The present situation is dominated by both continuing uncertainty and paradoxical market conditions.

Looking back at 2002, the U.S. economy did not do badly overall, with a growth in gross domestic product of 2.4%. That is below the average real GDP growth of 3.6% from 1992-2000, a period of great prosperity, but it was hardly a recession. Yet most Americans, especially those in real estate, felt 2002 was a terrible year. Why did we feel so bad?

The first reason is that the stock market did so badly. From the start of 2002 until the end, the NASDAQ composite index fell 49.5%. The S & P 500 dropped 23% in 2002. As of December 31, 2002, the NASDAQ was 80% below its peak in 2000.

The second reason we felt bad is that key sectors of the economy really suffered disaster --again --in 2002. They included the airlines, hotels, resorts, telecom firms, internet companies, and state governments, almost all of which had huge deficits.

The third cause of feeling bad was very slow job growth in the economy. From 2001 through March of 2003, the total number of civilian jobs rose only 0.3%, vs. an average annual increase of 2.4% during the 1990s. We lost 1.5 million non-farm jobs from 2001 to March 2003, a drop of 1.2%. Unemployment has just risen to 6.0%.

The fourth cause of feeling bad was a true recession in commercial real property markets, which I will discuss in detail later. It is still with us and getting worse.

The fifth cause of feeling bad was the general feeling of uncertainty resulting from our continuing war against world terrorism. That feeling was accentuated by the snipers in Washington, who showed just how easily two men could strike fear into an entire region. The chance of war in Iraq further accentuated this uncertainty in 2002.

If we look ahead, what is happening to all these causes of our feeling bad in 2002?

I am not a reliable stock market forecaster, because there is no such thing. But I think the stock market has passed its low point, especially since the war in Iraq has ended quickly. Since the first of 2003, all major stock indexes are up, and the NASDAQ composite has risen 53% as of May 2 --though still 70% below its peak. Earnings are improving, though a lot of corporate fraud remains to be revealed.

Unfortunately, the disastrous sectors of 2002 are not going to do much better in 2003. Airlines and hotels will remain depressed, and telecoms will not recover. The state governments will not get much aid from Washington, so they will have to cut spending and raise taxes and lay off workers. That offsets any federal tax cut to some degree.

Concerning job growth, jobs tend to recover more slowly than real GDP. True, the economy will soon get some type of fiscal stimulus from Congress. But none of the proposed packages are big enough to have much impact within 2003. Bush's proposal is the largest, and it was for $550 billion --but it is over 10 years, or $55 billion a year. The U.S. GDP is now running at $10.5 trillion. So $55 billion is a stimulus of only one-half of one percent. And Bush's plan would have little positive impact in 2003.

The fourth bad factor of 2002 was a recession in commercial real estate. For reasons I will discuss shortly, I believe that will continue in 2003. So this won't get better.

The one positive factor is that consumer confidence has improved because of the swift end of the Iraq war. That will help keep consumer spending strong, in spite of rising unemployment. But business investment is still plagued by financial uncertainties.

Thus, in 2003 and 2004, the world and U.S. economies will still both depend mainly on continued spending by U.S. consumers as the key growth mechanism. No other major economies in the world are expanding rapidly enough to stimulate world recovery, except China, which is being hurt by the SARS epidemic. But uncertainty has been reduced somewhat. This means 2003 ought to both exhibit more real growth than 2002, and make us feel much better than we did in 2003. Yet U.S. demands for commercial space will grow very slowly, even if the overall economy expands 3% or more in 2004.

Now let us 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.

I said then that this phase would not be as bad as the one we entered 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 50 regional markets as reported by CB Richard Ellis was 15.6% in the fourth quarter of 2002, vs. 13.1% in the same period in 2001. Fourteen regions had over 18% vacancy rates. In most, suburban vacancy rates were higher and downtowns, lower. The vacancy rate in San Francisco south of Market Street went from under 2% in 2000 to over 40% today!

The overall industrial vacancy rate in 42 markets as reported by CB Richard Ellis in the fourth quarter of 2002 was 11.5%, up from 10.1% one year earlier. Nine regions had over 15% industrial vacancy. New construction rose 60% in the 4th Q vs. the 3rd Q, but was 57% below the 1st 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.

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 they don't stimulate much new building yet.

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 most of 2003, and slowly transform into the gradual absorption phase as space markets start to soak up their present high vacancy levels --including lots of space out for subleasing or just not being used. So I do not expect much office space prosperity --and no new development --in 2003. But by the last quarter, vacancies may start falling and rents will stabilize. Probably the same forecast applies to industrial markets.

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 3 years, the next boom would not arrive before 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 5.7% 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, many more transactions were completed than in 2001 at the same time. But transaction levels are still well below those typical in similar parts of past cycles. That is a key result of prevailing 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 many investors think 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 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 solely 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 own 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 one of the results of more completely integrating real estate capital markets and all other capital markets.

However, the enthusiasm of 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 major vacancies are being avoided like auditors from Arthur Anderson. 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.

How long will this paradoxical situation 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.

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. True, this change would be partly offset by falling vacancy as space demands rose. This risk would be aggravated if interest rates rose before property markets recovered, squeezing property financing.

However, there are two reasons why the high dividends paid by REITs are likely to motivate many investors to hold REIT shares, even if stocks in general to move up. First, many private pension funds desperately need high dividends to help them achieve their "target" portfolio yield rates. If they don't meet those target rates, they have to take funds from current firm profits to meet their liabilities --and that means reducing reportable earnings. The second positive long-run factor for REITs is the increasing number of baby-boomers now retiring and thus needing current income.

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. True, many are waiting until property prices fall more.

This means entrepreneurial owners of older, relatively obsolete buildings with strong occupancy and yields should consider selling them now if they can still get good prices, before a return of general prosperity sucks yield-hungry money back into stocks and bonds. The most difficult decision in most asset markets is knowing when to sell, and now may be the time. In some markets, it may already be too late!

I have not said anything about markets outside the U.S. However, data from the London office market show a situation very similar to that in the U.S., with too much space available to sustain occupancy and rent levels but lots of investment money looking for someplace to go. I presume conditions are similar throughout Europe, aggravated by slower growth in most European economies than in the U.S.: 1.3% in real GDP for the Euro area from the 4th Q of 2001 to that of 2002, vs. 2.9% in the U.S.

In Asia, economic uncertainties from huge declines in tourism and falling orders in manufacturing have now also been aggravated by the SARS epidemic, so prospects for rapid general recovery seem dim.

I welcome comments from other Council members comparing conditions in markets outside the U.S. with those I have described here.

Altogether, near-future prospects for good operating profits in commercial space markets seem very poor for the rest of 2003 and well into 2004. And prospects for renewed development seem even worse until after 2004 --even if the overall economy starts growing fast in 2004. My motto for you is: You won't feel much glee --in two thousand three, and very little more --til after two thousand four. Good luck.