It is a pleasure to be here in beautiful Pinehurst to speak to you about the real estate outlook for the coming year. The outlook is obscured by the unusual nature of both the general economic cycle we are in, and its unusual relationship to the typical real estate cycle.

Concerning the general economic cycle, we are emerging from one of the shortest and shallowest recessions in modern times, caused in part by the bursting of the internet and telecom stock market bubble in the year 2000, and aggravated by attacks of September 11.

We apparently had only one quarter of actually negative GDP change, followed by the burst of growth in this year's first quarter of 5.6 percent, heavily influenced by inventory restocking. Most economists believe our GDP growth will slow sharply in the second quarter, but remain positive and gradually rising for the rest of the year. However, Prudential's economists are more optimistic about a rapid general recovery.

An unusual aspect of this cycle is that it was not caused by the Fed's raising interest rates, but by the "irrational exuberance" of the stock market followed by a cold shower of rationality and the events of September 11, 2001. Therefore, interest rates started out low and have been pushed even lower by the Fed. This has kept housing activities and prices very healthy throughout the entire overall downturn. That "wealth effect" has helped keep consumers spending.

The Economist recently had a cover story about "the houses that saved the world" because rising housing prices have continued to support strong consumer spending throughout the developed world, except in Japan, thereby averting a deep recession.

On the other hand, this means there will be no sharp increase in housing as the economy recovers, since housing is already strong. So the rest of the economy will have to recover without the stimulus of big gains in housing-related activities. That may slow down the rate of growth of the rest of GDP during the remainder of 2002.

As we look ahead, we can expect continued slow overall expansion of the general economy with interest rates remaining quite low for most of this year. Inflation will also remain low, unless oil prices spiked because of further trouble in the Middle East.

The largest uncertainty concerns the stock market. How fast will earnings recover? And do the high P/E ratios in the market based upon current but cyclically depressed earnings represent a serious overvaluation of stocks, or an anticipation that future earnings will rise enough to justify today's stock values by reducing future P/E ratios? If that is the case, then present stock values already have future earnings gains built into them. Under either interpretation, stock prices are not likely to rise sharply soon, or to recover the peak levels they reached in early 2000.

When I first started real estate forecasting, what was happening in the stock market was not critical to what would happen in real estate. But today, with so many real properties held by public REITs, movements of stock prices have become important to real estate too -- and not just by affecting corporate demands for space. So today to be a real estate forecaster, you have to predict not only what will happen in space markets, but what will happen in the stock market because so much property financing comes through it.

I believe I can reliably predict space markets, but I don't think anyone can predict stock markets worth a damn. So take all stock market forecasts with a ton of salt.

Current commercial property markets are exhibiting highly paradoxical conditions that seem inconsistent with past experience concerning real estate cycles.

On one hand, the balance of supply and demand in space markets -- especially in office and research space, but also industrial and apartments -- has become much worse in the past year and it does not seem likely to become more favorable soon.

Office vacancy rates -- especially in high-tech markets like San Francisco and Silicon Valley -- have jumped from very low -- even under 2% -- to 15-20%. In 49 major markets, the rate rose from 7.8% in the fourth quarter of 2000 to 14.2% in the first quarter of 2002 -- almost doubling. Rents are also falling commensurately.

This has occurred more from a dramatic shrinkage of demand than from any big overbuilding of new space, although a lot of new space has appeared and will continue to do so this year. There has been net negative office space absorption throughout 2001 and up to now in 2002. Many large firms that rented a lot of space have cut back on their usage and are now trying to sublease a lot of that space.

In industrial markets, vacancy has moved from 7.6% in the last quarter of 2000 to 10.1% in the same quarter in 2001. That is the highest industrial vacancy rate in many years. The rate is above 12% in 14 markets and above 15% in five markets.

Last year at this time, I said that space markets had moved from the development boom phase of the three-phase real estate cycle into the overbuilt phase. That movement has been accentuated by these developments. I thought this overbuilt phase would be milder than the one in the early 1990s, and I still think so. But it is going to last longer than I at first believed. Normally, in the overbuilt phase, as occupancy and rents fall, property prices also decline.

Yet, in spite of these adverse development in space markets, the market values of both many real properties and real estate investment trust (REIT) stocks have risen significantly. This is shown by movement of the NAREIT equity REIT stock index, which is up 68% since the beginning of 2000, including 18.6% since the 9-11 attack. These gains are in spite of a recent 5.3% drop in REIT shares. In addition, the NCREIF index has shown continued property appreciation until the last two quarters. And there are a lot of eager potential buyers for nearly all highly-occupied commercial properties that come on the market today.

Why should property prices be rising when the outlook in space markets is bad and getting worse? This is contrary to what has happened in nearly all past real estate cycles. The answer is that investors believe both current yields and future prospects for well-occupied real properties are superior to those in major alternative types of assets -- namely stocks and bonds. Many cash-laden and yield-hungry investors are under pressure to do something with their money that will produce better yields than stocks and bonds seem likely to exhibit in the near future.

The Federal Reserve's policy of driving down short-term interest rates in order to stimulate economic recovery has depressed yields on bonds to very low levels. Two-year government bonds are paying only 3.2% and 10-years are at 5.2%. The three-month Libor rate is below 2%. 2-year triple-A industrial bonds are paying less then 4%. And because the recession seems to have been so short-lived, there is some fear that interest rates will be rising soon, driving bond prices down. However, I believe the Fed will be very slow to raise short-term rates again unless signs of inflation get much stronger than seems likely in the near future.

In the stock market, although the major indexes have risen notably from their low points after the 9-11 attack, they are still way below their peaks in early 2000. Last Friday, the Dow-Jones industrial index was 16% below its peak, the S & P 500 index was 30.5% below its peak, and the NASDAQ composite index was still 68% below its peak. (Though the NASDAQ is also 73% higher than it was in 1995 -- and that is a slightly bigger increase than in the values of apartments in those 7 years.) All three of these indexes have recently been moving mostly sideways, with a lot of volatility.

Yet many think stocks are still overvalued because their Price-Earnings ratios remain high in historic terms, and earnings prospects are not great. Also, the quality of earnings is suspect because of widespread phoney accounting.

In contrast to these low-yielding investments, highly-occupied real estate promises to deliver a much higher level of current income, plus future appreciation prospects just as favorable as alternative assets. As I said earlier, the NAREIT equity REIT index has risen 68% since the start of 2000 when all those stock indices peaked and fell sharply. And REIT dividends in the 6-7% or higher range are better than can be had on most bonds and almost all corporate stocks. So investors believe they can get 8 to 9% yields on good commercial properties.

Investors burned in stocks -- especially from the collapse of NASDAQ high-tech values and shocks from Enron -- have shifted funds into both commercial real estate and housing to get higher current yields and greater value security.

Prices of existing homes sold rose 8.2% in the last year, 12.3% since 1999, and 57% since 1990, with no price collapses. Current levels of home sales activity, stimulated by very low mortgage interest rates -- reached record annual rates in January and February this year of 6.0 and of 5.88 million. People feel much more secure about putting capital into housing than stocks, especially with these low interest rates. And rising home equities fuel consumer spending.

Thus, the burden of having a reputation for a possible value collapse has shifted from commercial real estate -- where it was in the 1990s because of the debacle of 1990-1993 -- to stocks, especially high-tech stocks, because of the bursting of the dot-com and telecom bubble of 2000.

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 notable amounts of commercial property makes sense, though pension funds have been slow to do so.

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 substantial vacancies are being avoided as though they were auditors from Arthur Anderson. Investors recognize that demands for space are still shrinking, not rising, and are not likely to rise enough in the near future to offset the huge available supply of sub-leaseable space. So the counter-trend movement of property prices is confined to a sub-portion of the whole market.

Another peculiarity of this market is that the level of transactions is very low. Leasing activity is low because so few firms want additional space, given current recessionary conditions. Some sales are occurring, but many fewer than in a normally sound market.

Buyers are slow to make offers because of uncertainty about the values of properties with lots of vacancy in a market where few leasing transactions are setting likely future rents. Property owners are deterred from selling by similar uncertainty. Pension funds are reluctant to sell because they don't know what they would do with the money.

This situation differs greatly from 1990 and 1991. Then owners of high-vacancy properties were mainly developers with heavily mortgaged properties. High vacancies forced them to default, leading to foreclosure by banks and insurance companies. The latter then sold such properties to high-risk "vulture funds" or "opportunity funds." After the economy expanded enough to improve property market conditions, those high-risk funds sold the properties. Yet transactions were also initially quite low in 1990-1992 because it was so difficult to get banks and insurance companies to make loans.

Today, many owners of troubled commercial properties are either REITs with much lower leverage than traditional developers -- hence not under as much pressure to default or sell -- or large firms that have been using the space themselves, or pension funds. They would rather refinance at today's low rates than sell at bargain prices.

Many large firms have shrunk their operations because of the recession and the collapse of dot-com and telecom markets, but they still occupy the resulting surplus space. In some cases, they have put such space on the sublease market. But many are simply sitting on more space than they need because they cannot see any easy way to convert it into income or cash. No one has reliable data on how much surplus space such firms really have. This adds to the great general uncertainty.

Also, the fact that so much surplus space is in the hands of large firms or investors not facing bankruptcy reduces the pressure on owners to sell, as compared to the early 1990s. That is another factor keeping the number of transactions low.

How long will this paradoxical situation last? One way it could end is by the return of strong general prosperity. That would eventually expand space demands on the one hand, and raise interest rates and stock prices on the other -- thereby attracting more investors away from real estate back into stocks and bonds.

If yield-seekers shifted capital away from real properties as yields on alternative assets rose, the upward pressure on property prices would diminish, and such prices might fall. True, this change would be partly offset by falling vacancy as demands for space rose along with general prosperity. That would be part of the normal gradual absorption phase of the real estate cycle, before rents increased enough to stimulate new building.

Yet vacancy rates are now high enough so that even expanding space demand will not create much upward pressure on rents and prices for at least two years, and perhaps longer. Thus, even the end of the current recession will not immediately end the oversupply in real estate space markets and make vacant properties well.

In relative terms, the overbuilt situation today is not as bad as in the early 1990s, but in absolute terms, the amount of vacant space available now is even larger because so much more space was built in the 1990s as the economy grew. So it will take a sizable recovery to soak up all the vacant space.

So until general economic activity rises enough to drive up yields on alternative investments, the current paradoxical situation in commercial real state is likely to persist. I believe it will last through this year, but perhaps not much longer.

This means entrepreneurial owners of older, relatively obsolete buildings with strong occupancy and yields should consider selling them now, 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.

One crucial aspect of the current real estate financing situation is the increased riskiness of owning real properties through REIT shares because of their need to compete with other potentially more dynamic forms of stock investments. REIT shares did poorly in the late 1990s when space markets were in reality booming. Why? Because greedy investors shifted capital into internet and telecom stocks that shot upward through speculation. The resulting rapid appreciation of high-tech made real estate-- both REIT shares and property ownership -- seem dull and listless. So fad investors avoided REITs.

This whole "bubble" experience shows that public markets are NOT more efficient or more rational than private markets, as many Wall Street advocates have claimed. Public markets are even more subject to fad investing than private markets.

After all, many high-tech industries are new and innovative. So they have the potential to grow earnings much faster than real estate, which is an old and established industry. Investors ignored the risks of high-tech and its lack of dividends and so scorned stodgy REITs. But when high-tech stocks tanked, REITs looked good -- and they still do, even though property markets have recently weakened substantially, as I noted before.

Recently, REIT shares have moved downward, probably because the worsening conditions in space markets have become more well known. If a strong recovery occurred in high-tech sectors and their earnings started booming again, I believe a lot more money would shift out of REITs back into high-tech, high-risk stocks.

This linkage of the availability of funds for real estate with the prosperity of competitive stock investments is one of the prices our industry pays for expanding its sources of funds by tapping public capital markets. In some parts of the cycle -- as in the past two years -- broader funding sources are beneficial to real property owners. In other parts of the cycle, as just before 2000, they are harmful, at least relatively, because other types of investment seem more dynamic and therefore more attractive to capital suppliers.

Ironically, the stronger a general economic expansion, the greater the demands for space, the tighter property markets become, and the more cash flow real properties generate. But the same prosperity can make alternative investments look even sexier, and may reduce capital availability to real property markets. I do not think there is much danger of such a strong recovery in glamorous sectors in the very near future. But it is something for investors to think about over the long run.

It provides one reason why directly owning real estate to at least some extent has some advantages over investments in REIT shares, in spite of the latter's greater liquidity.

In conclusion, we are experiencing some abnormal conditions in real property markets today. Investments other than real estate -- namely stocks -- have lost appeal even faster than owning real properties, even though space markets have become much weaker in the last two years. That has made well-occupied real estate look even better relatively than it does absolutely. This situation presents opportunities to those willing to take advantage of favorable property market conditions that may not last long. I presume you are among those fortunate people.