CHAPTER 6

Property Types

INTRODUCTION

RESIDENTIAL RENTAL PROPERTY
Some Definitions
The Demand for Rental Housing
Investment Prospects

OFFICE BUILDINGS

INDUSTRIAL PROPERTIES

SHOPPING CENTERS AND OTHER RETAIL ESTABLISHMENTS

OTHER TYPES OF REAL ESTATE
Hospitality Properties
Undeveloped Land
Senior Assisted Living and Continuing Care Retirement Communities

SUMMARY

KEY TERMS

TEST YOURSELF

PROBLEMS FOR THOUGHT AND SOLUTION

INTERNET EXERCISE

ADDITIONAL READINGS

LEARNING OBJECTIVES

After reading this chapter, students will be able to:

1. List several advantages and disadvantages of investing in apartments, office properties, industrial properties, shopping centers, hospitality properties, undeveloped land, and senior assisted living/continuing care retirement communities.

2. Describe the differences between Class A, B, and C office buildings

3. Discuss the major demographic trends likely to affect the rental housing market over the next 20 years.

4. Describe the differences between neighborhood, community, regional, super-regional, and specialty shopping centers.

INTRODUCTION

Many different types of real estate exist, including office buildings, apartments, industrial buildings, shopping centers, and undeveloped land. Properties within each category can vary greatly in quality, age, size, and other characteristics. For example, the office building category includes both high-rise structures located in central business districts and one-story doctors’ offices located in rural areas. Industrial buildings can range from large production plants to mini-storage facilities. Moreover, potential returns and the degree of risk also vary significantly with property types. A well-located office building leased to high quality tenants on a long-term basis has risk and return characteristics that are very different from investments in raw land at the urban fringe. In order to make acquisition decisions that are consistent with their investment philosophies and objectives, investors must be aware of the advantages and disadvantages of the various property types.

This chapter presents an introductory discussion of the most common types of property. Residential rental properties include apartment buildings of various sizes, single-family homes, duplexes, triplexes, fourplexes, government-assisted housing, and housing for the elderly. The term commercial property encompasses all nonresidential real estate, including office buildings, shopping centers, industrial and warehouse buildings, and hospitality properties such as hotels and motels. After the discussion of residential rental properties, sections on office properties, industrial properties, shopping centers, and other types of real estate such as hospitality properties, undeveloped land, and senior assisted living and continuing care retirement communities follow.

RESIDENTIAL RENTAL PROPERTY

Some Definitions

The majority of residential rental units are contained in multifamily structures; that is, apartment buildings that contain five or more housing units. Multifamily structures are often classified by developmental density and architectural style. High-rise apartment buildings are popular in more major city centers where the price of land is at a premium and the intensive use of land is a necessity. Buildings classified as high-rise have at least 10 to 15 stories. Larger structures may have a variety of recreational amenities, a continuously staffed front desk or all-night attendants, and retail establishments such as convenience stores and newsstands.¹

Mid-rise apartments range in height from four to nine stories and are found in both cities and suburbs. Mid-rise apartment buildings in city centers may provide underground parking or no parking at all, whereas their suburban counterparts usually have parking available. Inside, a common hallway provides access to each unit on a floor. Some buildings provide a wide range of amenities, as well as on-site management and service personnel.

Garden apartments have a relatively low density of development and thus are often located in suburban and nonurban areas where land is comparatively less expensive. These complexes may consist of numerous low-rise buildings, including a separate building containing a management office and clubhouse. The demand for on-site exercise facilities has increased significantly in recent years. Large garden complexes are also likely to have spacious lawns, extensive landscaping, and numerous outdoor amenities including swimming pools and tennis courts.

Condominium complexes typically contain units with adjoining walls but with separate entrances and patios to each unit and ample parking. Units may be occupied by the owner or leased to a tenant. The condominium arrangement provides the owner-investor with individual ownership of the unit and joint ownership of the common areas, parking area, and recreational facilities. Generally, management control of the complex rests with an owners’ association, which has responsibility for maintenance, taxes, insurance, water and sewage, and common-area facilities. The owner is responsible for the interior of the unit, including the interior walls. Owner-occupied condominiums have served as a bridge from rental to the ownership of single-family detached homes for many families, especially during periods of high interest rates when ownership becomes less affordable.

The Demand for Rental Housing

Like all economic goods, prices and rates of return on various types of rental housing depend on the demand for, and the supply of, units. The demand for rental housing is influenced by changes in population, household incomes, and household tastes.

The most important influence on rental housing demand in a local area is population. However, sheer changes in population alone do not explain changes in the demand for housing. For example, housing demand is more affected by the change in the number of households than by the change in the number of people. In states with high divorce rates, such as California, divorce, which creates two households from one, is a major contributor to the demand for housing. Conversely, numerous recent articles document the growing acceptance among adult children of moving back in with Mom and Dad for extended periods of time, thereby reducing the demand for housing.

In addition to household formations, the demand for rental housing is extremely sensitive to the proportion of households that own versus rent. General demographic characteristics such as age, sex, and occupation are also important determinants of rental housing demand. For example, many analysts argue that the demand for rental housing is, and will be, negatively affected by the aging of the baby boom generation. As more and more boomers cross into middle age—prime home buying years—the demand for rental housing, all else the same, has fallen. Moreover, as the boomers are replaced by the much smaller Generation X, the prime renter-age category of 18–34 years old will shrink even further—from about 70 million persons in 1990 to 63.5 million in the year 2000. These negative age-cohort effects on rental housing may be offset somewhat by increases in groups that tend to favor apartments over single-family owner-occupied housing: single persons, recent immigrants, and nontraditional families (cohabitants). In addition, senior rental housing is predicted to be one of the great growth areas over the next two decades. It is important to point out, however, that many of these demographic trends, such as the aging of the baby boomers, can be (and were) predicted with some degree of accuracy. Thus, their anticipated effects on the demand for housing are already reflected in current prices. Price adjustments due to these factors occur only when expected demographic trends are altered.

The second major factor affecting rental housing demand is income. Households tend to consume more housing as their incomes increase. Thus, future housing demand is directly linked to changes in household incomes. Forecasting income changes in a particular market requires an understanding of local business cycles, the regional and national business cycles, and employment trends. (These issues are further discussed in Chapters 9 and 11.)

The final major determinant of rental housing demand, and certainly the least quantifiable, is taste or lifestyle. Will households spend more of their discretionary income on housing or will increases in leisure pursuits and vacations consume a larger proportion of household incomes? Will the current trend toward more and larger bathrooms continue, or will renters in coming years decide that larger kitchens are a priority? Are larger, well-equipped exercise facilities in, and tennis courts out? Are upscale apartments with single-family features (an extra bedroom, garage parking) in, and condominiums out? The answers to these and many related questions will have a significant effect on rental property values over time.

Investment Prospects

The demand for quality housing has continued to be strong over the past few decades. Also, the demand for rental housing is usually not severely affected by short-run downturns in the general economy, so vacancy rates in residential properties are generally lower than those for other types of rental property. For example, the National Council of Real Estate Investment Fiduciaries (NCREIF) reports that during the severe real estate recession of the late 1980s and early 1990s, the average investment-grade multifamily structure declined in value just 14 percent from the peak of the multifamily market in 1985. In contrast, industrial and office properties declined, on average, 40 percent and 54 percent, respectively. Moreover, the short-term lease contracts that normally exist between landlords (investors) and tenants in residential rental properties allow landlords to frequently adjust rents to market levels when the leases expire. This is especially important during periods of high inflation or rapidly increasing demand for rental housing. Finally, residential real estate affords small investors many opportunities to invest by taking direct equity positions in modest, local structures. Although the returns on residential rental properties tend to be somewhat less risky than other property types, this does not imply that they are generally better investments. Why? Investors typically must pay a higher price for less risky cash flows, all else the same, and this reduces their expected return.

A major drawback of investing directly in residential rental property is the heavy property management burden. Unlike commercial property, rental housing is in use 24 hours a day. This continuous use tends to increase the demand for maintenance, repairs, and other services. In addition, tenant turnover can be rapid because leases are relatively short. All of the above reasons imply large commitments of time for investors who decide to manage their own properties, or a substantial commitment of funds (usually 5 to 8 percent of effective gross income) by investors who use professional property managers.

OFFICE BUILDINGS

The office building as it is known today started with the introduction of “skyscrapers” in the late 19th century. The concentration of skyscrapers within a city became known as the central business district (CBD). During the latter part of the 20th century, we have witnessed the development of multiple business districts within cities and in the suburbs. The high price of land and increasing congestion of the CBD have fueled the growth of multinodal metropolitan areas. This decentralization of the urban landscape is often referred to as urban sprawl.

While there is no definitive standard for classifying office buildings, the real estate profession commonly refers to office buildings in the following way:

• Class A. These buildings usually command the highest rents because they are most prestigious in their tenancy, location, and overall desirability. They are usually newer structures located in the CBD, and are typically owned by institutional investors such as insurance companies, real estate investment trusts, and pension funds. Class A properties also have been a prime target of foreign investors in recent years.
• Class B. The rents in these buildings are usually less than in Class A buildings because of a less desirable location; fewer amenities; less impressive lobbies, elevators, or appearance; or a relatively inefficient layout of the leasable space.
• Class C. These buildings, which were usually once Class A or B, are older and reasonably well maintained but are below current standards for one or more reasons. Rents are set to match the rent-paying ability of lower-income tenants.

The two most important determinants of an office property’s classification are age and obsolescence. However, older buildings can be classified as Class A structures if they accommodate the current needs of potential tenants. If the space cannot be improved and updated, the class of the building is likely to decline. For example, many office buildings—even relatively new ones—cannot be easily retrofitted to accommodate technological advances in computer networks and telecommunications.

According to the Institute of Real Estate Management (IREM), there are 12 fundamental criteria for classifying office buildings: location, ease of access, prestige, appearance, lobby, elevators, corridors, office interiors, tenant services, mechanical systems, management, and tenant mix.² Most of these factors are interdependent; for exam-ple, highly prestigious buildings are likely to have attractive appearances, an impressive lobby, and quality tenants. The prestige of a building is also a function of its location. For suburban buildings, access to major highways and linkages with places such as restaurants, high-income residential areas, and shopping facilities are extremely important.³

The demand for office space is directly related to the level of office employment, which, in turn, is related to the demand for services supplied by the occupants of office buildings. Increases in the number and size of service employers such as doctors, lawyers, accountants, real estate firms, commercial banks, mortgage banks, and environmental consulting firms translate into expanded demand for office space. The demand for the services supplied by the occupants of office space is affected by population changes; local, regional, and national economic factors; and changes in the tastes of companies and households.

The growth of the service sector of the U.S. economy during the 1970s and 1980s  created a tremendous demand for office space. High-rise office buildings in downtown areas, low-rise buildings in suburban office parks, and office condominiums proliferated in many urban areas. However, similar to its effect on residential properties, the severe real estate recession of the late 1980s and early 1990s brought new office construction to a virtual standstill as office property values fell well below construction costs in most markets.

As investments, office buildings have some distinct characteristics. For example, long-term leases, when signed with quality corporate tenants, are relatively secure. Also, most office leases today are indexed for inflation and sometimes for property expenses (e.g., property taxes). Furthermore, office space is increasingly subject to “net leases” that shift much of the operating risk directly to tenants.⁴ Another characteristic has been the strong demand for office space in many major urban areas, which has been fueled by a conversion of the U.S. employment base from manufacturing to service jobs.

The disadvantages of office-property investments are related to the unique characteristics of office buildings. Office-property investments may be riskier than residential rental property because of the higher degree of expertise required to manage and lease office space. Management and leasing errors by inexperienced agents often have devastating effects on the cash flows from office buildings. Because prestige is important to the success of office developments, leasing to lower-quality tenants, for example, places a building in a lower quality category in the eyes of the market. In addition, significant re-leasing costs (including tenant improvements and leasing commissions) are often required to make the space ready for new tenants when vacated by the current tenant. Even worse, rapidly changing technology and tenant tastes can quickly cause office buildings to become outdated—if not obsolete. (See Real Estate Focus 6–1.)

Several challenges are facing the office sector as we approach the turn of the century. First, many corporations have begun downsizing their employee staffs. This is especially evident in industries such as commercial banking and insurance. Moreover, corporations are not only cutting staff, they are taking every opportunity to reduce the amount of space used by each (retained) employee. This pervasive trend is in contrast to recent decades when employers tended to increase the amount of working space provided per employee. The reduction in space per employee is consistent with the much publicized increase in office telecommuting, that is, working from the home, vacation spot, or even car, via fax machines, computer modems, and cellular phones. Another trend expected to reduce the demand for space per employee is hoteling—having salespersons, the auditing staff of accounting firms, and other office personnel who are frequently out of the office share the use of unreserved space when they need to be in the office.

Second, the explosive employment growth of the late 1970s and early 1980s fueled by baby boomers and women entering the workforce is subsiding, providing for considerably less absorption of office space. In the downtown office sector, the best-performing markets will feature 24-hour environments with strong residential, retail, and cultural districts close to the CBD. Big losers may be eight-hour business districts in cities beset by poverty, crime, the lack of significant residential communities, and poor mass transportation. The challenge for the developers of new office space is to install systems that can handle future technological changes and reduce retrofitting costs.⁵ A summary of changing office supply and demand factors, and the likely responses to those factors, is presented in Exhibit 6–1.

INDUSTRIAL PROPERTIES

Industrial properties range from large plants and factories to small warehouses. Plants and factories are special use properties and are not easily converted to other uses. Thus, they are relatively risky and are usually avoided by investors, except those who specialize in the specific production processes employed at the plant (i.e., the companies that use the facilities).

The most popular type of industrial property investment, especially for institutional real estate investors, is the warehouse, which provides space for the temporary storage of goods. Business operators frequently choose to lease, rather than own, their required storage space. Leasing is a frequent choice because of income tax considerations and because leasing frees up capital to invest in other aspects of the business. Many industrial tenants prefer to lease space on a long-term basis with net leases (where most or all of the operating expenses are paid by the tenants). Thus, warehouses provide investors with relatively low-risk, long-term investments that often fit the investment objectives of conservative investors, such as pension funds.

Warehouses are relatively simple to construct, have a long economic life, and require little management effort compared to other income-producing properties. Generally, warehouse buildings—with their open space for storage—are the most resilient of the major property types to functional obsolescence. However, the growing length and width of trucks require distribution warehouses that can accommodate them. This need has rendered many warehouses partially, if not completely, obsolete. Real Estate Focus 6–2 discusses additional trends in the design of warehouse properties.

The demand for industrial space is derived from consumer demand for products by the industrial sector. For example, increases in consumer demand for bottled beverages increases the demand by bottlers for storage space. Increases in the number and size of industrial firms such as computer chip manufacturers, beer producers, grocery stores, and furniture makers translate into expanded demand for warehouse space. As in other sectors of the economy, the demand for the services supplied by the users of warehouse space are affected by population changes; local, regional, and national economic factors; and changes in the tastes of companies and households.

Recently, special-use properties, such as miniwarehouses and research and development buildings, have become popular with noninstitutional investors. Miniwarehouses are located close to businesses and apartment units that have little space available for storage. In many areas, occupancy rates in miniwarehouses have been extremely high. Research and development buildings can be extremely risky because a property specially designed for the needs of one tenant may not be suitable for the next tenant; thus, substantial costs may be involved in readying the property for re-leasing.

In recent years, much of the development of light industrial and research and development use has occurred in industrial parks. These sites resemble residential subdivisions and offer a controlled environment with buildings designed to accommodate a wide variety of tenant needs. Limited partnerships, discussed in Chapter 5, develop and manage many of these facilities.

SHOPPING CENTERS AND OTHER

RETAIL ESTABLISHMENTS

Retail establishments are found in a variety of forms. The simplest is a freestanding retail outlet (e.g., a fast-food outlet). Many retail establishments today, however, are found in shopping centers. Shopping centers, more than freestanding establishments, are popular with individual investors and institutions that invest in income-producing properties.

Before discussing the advantages and disadvantages of shopping-center investments, consider the various types of shopping centers:

1. Neighborhood or “strip” center. This type of center is located for the convenience of a close-by resident population. It contains retail establishments offering mostly convenience goods (e.g., groceries and drugs) and services (e.g., barber shop and dry cleaning). These centers are usually “anchored” by a large chain grocery store or drugstore. The gross leasable area of the anchor(s) and nonanchored tenant space is approximately 50,000 square feet, but it may be as large as 150,000 square feet. The trade area of a shopping center is the geographic area from which it draws its customers. A strip center’s trade area is typically within a 5- to 10-minute drive of the center. Such a center can usually succeed in a trade area with a population of 1,000 to 2,500 if it is well located.
2. Community center. This is a larger version of a neighborhood center. This type of center is often anchored by a discount department store and may include outlets such as clothing stores, banks, furniture stores, video rental stores, fast food operations, and professional offices (e.g., dentists). The gross leasable area (GLA) is usually three times that of a neighborhood center. A community center’s trade area is usually within a 10- to 15-minute drive of the center. Most of these centers are early generation malls.
3. Regional and super-regional centers. Regional centers usually have at least two anchor tenants that are major department stores (e.g., Sears) and at least 200,000 square feet of gross leasable area devoted to nonanchor tenants. Major tenants are national chains or well-established local businesses that have high credit ratings and significant net worth. These retailers draw people from a much larger area than the neighborhood or community centers. Minor tenants are located between the anchor tenants to capture customers. Often regional centers contain several stores of one type (for example, three to five shoe stores). Many include small fast-food outlets arranged in food courts. Regional centers usually serve a population of 150,000 to 300,000. In recent years, through expansion of regional centers and through new development, super-regional centers have emerged. These centers may have as many as five or six major tenants and hundreds of minor tenants in over a million square feet of space.
4. Specialty shopping centers. These centers are characterized by a dominant theme or image. Many in downtown areas are located in a rehabilitated historic structure and area. Two variations of specialty shopping centers have increased in importance in recent years. Outlet centers sell name-brand goods at lower prices by eliminating the wholesale distributer. Retailers at off-price centers are able to offer large discounts on name-brand merchandise that consists of factory overruns, seconds and discontinued items, and overstocks from other stores.

The increased development of power centers is an important retail trend. Power centers have gross leasable areas ranging from 250,000 to 750,000 square feet. The dominating feature of a power center is the high ratio of anchors to ancillary tenants. Typically, power centers contain three or more giants in hard goods retailing (toys, electronics, home furnishings, etc.). Home Depot and Wal-Mart are two prominent retailers that frequently locate their stores in power centers. The characteristics of the various shopping center types are summarized in Exhibit 6–2.

The retail tenant’s primary concerns are the availability of adequate space for its business, the volume of consumer traffic generated by the center, and the visibility of the tenant’s location within the center. Additional challenges are presented by the special requirements of some tenants. For example, furniture and appliance stores require loading docks, food service providers have garbage disposal problems, and supermarkets need an abundance of close-by short-term parking.⁶

Shopping-center investment is probably the most complex of income property investments. The market for shopping centers is dynamic. On the demand side, the growth of an urban area and national economic events can quickly alter market characteristics (e.g., family income and population density). On the supply side, competition for market areas is intense. Smaller centers are generally riskier than larger ones because they are more susceptible to competition from new strip centers and retail areas. One implication of these changing conditions is that the owners and managers of the center must be constantly aware of whether the tenant mix of the center is properly serving the market. Shopping center developers and investors base their decisions on a demographic profile of the area that quantifies the number of people who are likely customers, the discretionary incomes of these customers, and their retail expenditures. Developers of new centers are aware that they must attract customers away from other shopping centers.

The ownership arrangements and lease contracts between owners or managers and tenants are generally quite complicated. For example, hours of operation, types of goods sold, common promotions, freight handling, and share of common areas maintenance (CAM) expenditures must be negotiated. Nonanchor tenants often make flat or indexed rental payments plus an additional payment based on some percentage of their gross sales. As the sales volume of the tenant increases through inflation and growth in retail demand in the area, the investor’s cash flows should increase accordingly. These arrangements are termed percentage leases, and they allow the owner(s) to share in the tenant’s ability to generate sales volume. Tenants also typically share in paying the center’s operating expenses. Lease clauses providing for adequate rent and operating-expense sharing are a source of risk to investors.⁷

Several important issues and trends may have a significant effect on the viability of some shopping center investments. First, the United States is overstored. Since 1972 the amount of retail space per capita has almost tripled to 20 square feet. Second, homogeneous mass-marketing approaches are becoming increasingly ineffective. Racially, culturally, and economically, the United States is diversifying as minority populations grow and the middle class shrinks. Successful chain stores must modify their product mix across stores to fit submarket demographic profiles. Third, the eroding purchasing power and increased consumer debt burden of the typical household may have far-reaching effects on shopping center returns. Another uncertainty is the impact of electronic shopping (through the Internet or cable TV) on retail establishments. Trips to malls are down as time-pressed consumers are shopping closer to home. Also, as suburban crime becomes a more pressing issue, the safety and security of a shopping center will increase in importance.⁸

OTHER TYPES OF REAL ESTATE

Although residential, office, industrial, and retail are the most common uses of real property, there are numerous other uses for space such as hospitality properties, continuing care (nursing home) facilities, and even undeveloped land.

Hospitality Properties

Hotels are establishments that provide transient lodging for the public as well as meals and entertainment. Motels are establishments located on or near a highway that are designed to serve the motor traveler. Hotels and motels serve several distinct markets including the traveler (transient market) and the visitor or conventioneer (destination market). Convention hotels cater to meetings of businesses and other organizations and are often located in the downtown areas of major cities. Resort hotels are located near entertainment and vacation-related activities.

The markets for hospitality properties are highly susceptible to changes in general economic conditions and, because there are no leases in hospitality properties, these types of investments may be riskier than other income-property investments, although with high risk comes the opportunity for high returns. Also, because these properties are not subject to long-term leases, they are more flexible and less vulnerable to unexpected increases in inflation. Hospitality space is usually valued on a per-room basis. For example, major hotels sell for $80,000 to $90,000 per rentable room.

The success of a hospitality investment is largely driven by its location and how well the services offered by the hotel match the needs in a particular market. Income projections are complicated because many of the income and expense items fluctuate widely with changes in seasonal demands. Therefore seasonally adjusted averages should be used as inputs into the discounted cash flow valuation model for hospitality properties.

The success of hospitality property investments is highly dependent on management. A hotel is a service business. Thus, managers should be versed in all aspects of this type of business, not just in collecting room rents and providing maintenance. Because cash flows are dependent on the management of the hospitality business, the ownership of hospitality properties by passive third-party investors is much less common than with the other major property types. As a result, properties often are owned by one of the national corporate chains. Properties that are owned by third-party investors are typically run by management chains. When the chain works under contract for a percentage fee, the cost of management is treated as a normal operating expense by the owner. In an alternative arrangement, institutional (third-party) investors may lease the property to specialized operators. In this case, the investors have an ownership interest in a property that produces lease payments that are net of all operating expenses.

Undeveloped Land

Undeveloped, or “raw,” land is one of the riskier real estate investment opportunities. Investors in raw land are speculating that urban growth will produce increasing demands for conversion of undeveloped land to apartments, shopping centers, and other uses. The returns investors receive from investments in undeveloped land depend entirely on land value increases because undeveloped land does not generate income—unless minerals are extracted or the land is put to some agricultural use. Sufficient increases in value may come soon, they may come years from now, or they may never come. Forecasting urban growth, much less its timing and direction, is a very inexact science. Moreover, the increasing public scrutiny being given to all types of real estate development has dramatically increased the legal, political, and environmental risks associated with land development. At a minimum, the land investor must be environmentally sensitive and well informed about locations that may have restrictions on their future development. Examples include officially designated wetlands, areas with endangered species, upland habitats, and areas with underground toxic waste. Environmental issues are discussed in more detail in Chapter 10.

There also are unavoidable carrying costs in land investment. These costs include property taxes, interest payments if the properties are partially debt financed, and the opportunity cost of the invested equity. In addition, the income tax features of these investments are not favorable. Land cannot be depreciated for tax purposes, and there are limitations on interest deductibility. Lack of liquidity is also a feature of raw land. However, because of the relatively high risks, higher returns should be expected on raw land investments.

The success of undeveloped land investments depends on good location in relation to the pattern of growth and the following other considerations:

Raw, or undeveloped, land is not the same as developable land. Before construction of the improvements to the land can begin, a great deal of infrastructure must be in place. For example, the land must be cleared and graded and streets, sidewalks, and utilities must be put in place. Increasingly, some of the land must also be set aside for greenways and community areas.

Senior Assisted Living and Continuing Care Retirement Communities

More than one out of every five Americans will be 65 or older by 2030. Thus, a major growth sector in urban land use over the next two decades will be senior housing and continuing care (nursing home) facilities. Elderly parents are increasingly unlikely to live at the homes of their adult children. Relatively healthy seniors not yet in need of nursing home facilities are seeking alternatives. Many analysts project that these seniors will increasingly demand housing with apartment-style units in a community setting with food services, planned activities, and attached medical-nursing home facilities. As with hospitality properties, the success of senior assisted living projects is highly dependent on management because of the large number of services provided on-site. As a result, the ownership of these properties by small, owner-operators or by passive third-party investors is likely to be much less common than with the other major property types.

 EXHIBIT 6–1

Changing Office Supply and Demand Factors

·           Factors Affecting Supply and Demand in the Year 2000
            New technologies—the virtual office, E-mail, telecommuting
            Cost-containment—reengineering of corporate America, outsourcing
            Office sharing—hoteling and work-at-home patterns
            Changing management practices—decentralized decision making, resource flexibility
            Demographic forces—two-worker families, aging of baby boomers, labor-force mobility
            Employee satisfaction—health consciousness, child care, colleague interaction
            Exterior office environment—security, access, amenities
            Interior office environment—air quality, comfort, security
            Globalization—multinational companies, overseas influences

·           Corporate/Entrepreneurial Responses to Changes in Demand
            Changing norms for space per employee by tenant type and activity
            Office of the future—accommodating new technologies
            Energy efficiency and ergonomics—how do office space users apply these principles?
            The production function of the service firm—land, labor, and capital (office space costs             relative to other costs of doing business and relative to historic occupancy costs)

·           Impact on Future Office Investment Performance
            Net effects on office demand (absorption, rents)
            Regional variations (sunbelt versus north, older versus newer cities)
            Supply response (renovation of older offices, advantages of new construction)
            Effect on investor demand (pricing, capital flows)
            Implications for asset management
            Implications for investment and exit strategies

            Source: Investment Strategy Annual (Chicago: LaSalle Advisors, 1996).

REAL ESTATE FOCUS 6–1

GM Leads Office Bargain-Hunters Downtown

The jewel of Detroit’s skyline, the Renaissance Center, opened in 1976 at a cost of $357 million. It would take at least $750 million to replace it today. So what is the sprawling, five-tower office-and-hotel complex worth to a buyer? $73 million is what General Motors Corp. agreed to pay in a deal completed in October of 1996.

The nosedive in Renaissance Center’s value reflects the fate of many big office complexes built in the 1970s and early ’80s. Outdated but not obsolete, they are finally finding buyers after a long slump in the downtown market—albeit at fire-sale prices. The reason: Rents and construction costs in booming suburban markets now approach or even exceed downtown levels. Meanwhile, quality-of-life improvements in some cities have made them attractive again to deal-hungry investors flush with capital.

For Detroit, GM’s purchase could mean that Renaissance Center will finally realize its promise and spur a genuine downtown revival. The relocation of GM’s headquarters to the riverfront complex is expected to encourage other businesses to locate downtown, boost property values, and perhaps even jolt a moribund construction market that has seen just three major office buildings erected downtown in the last 20 years.

GM plans eventually to be the sole occupant of Renaissance Center’s office space, and as such its deal is unusual. Few companies have GM’s resources, space needs, or close ties to a city, but a lot of other companies are bargain-hunting downtown. “The irony is that downtowns have to compete on price at all,” says Robert Bach, national director of market analysis with the real estate firm Grub & Ellis Co. in Los Angeles. “When these buildings were built in the ’70s and ’80s they were the cream of the crop.” But the vogue for vast office complexes has passed. Today, corporate landlords want office space without the added costs and upkeep on public plazas and retail shops. “The Renaissance Center’s sense of scale is out of whack” with today’s more modest needs for space, says Jeffrey Shell, a senior managing director with Cushman & Wakefield in Southfield, Michigan.

Source: The Wall Street Journal, October 1996.

REAL ESTATE FOCUS 6–2

Trends in Industrial Warehouse Design

Investors are concentrating on “higher cube” boxes, with clear space of up to 30 feet, and on “flat-flat” floors that can accommodate picking systems, which enable access to higher storage stacks. Warehouses have evolved from storage facilities into logistically advanced distribution-processing centers with goods “through put” rather than inventoried. Frequently, shipments are trucked in from the factory, delivered to one loading dock, where they’re bar coded and moved inside, and then are divided and quickly reloaded onto trucks waiting at the other end of the building.

Major shippers place an increasing premium on accurately timed deliveries and pickups along the hub-and-spoke points in their distribution networks. Bigger-cube warehouses are more efficient, allowing more cargo to be packed into the facility and providing space for larger truck-turning radiuses. They should have fiber optic cabling and sufficient power sources to run inventory tracking systems, as well as high-pressure early-detection sprinkler systems. But the logistics process will become increasingly high-tech, and adaptation to ever greater demands for speed and reliability will be an ongoing process.

Source: Emerging Trends in Real Estate (Chicago: Equitable Real Estate Investment Management, Inc., and Real Estate Research Corporation, 1997).

REAL ESTATE FOCUS 6–3

Malls Add Fun and Games to Attract Shoppers

Shoppers who wander onto the fourth floor of the new Circle Center mall in Indianapolis are unwittingly taking part in an experiment that could reshape the American mall. There’s nowhere up there to shop. Teenagers wearing space-age wrap-around goggles lob “virtual” grenades at one another. A young girl gapes as her father is hoisted horizontally in a sling, pokes his head into goggles, then clumsily smashes his virtual hang glider off the walls of a canyon (also virtual). An airline steward disappears into “Virtual World” for a death-race through mining tunnels on Mars.

After spending a few dollars on these flashy games, the mall visitor can head for a nine-screen cinema or one of seven theme restaurants and bars. Together, they are the prototype for Simon Property Group Inc.’s push into mall entertainment.

“People don’t have to go to Orlando to be entertained,” proclaims David Simon, president and chief executive of the Indianapolis-based mall-development company. “Companies are figuring out ways to make it portable. And what better place to locate than in a mall?”

There is little doubt that malls need to distinguish themselves in the crowded retail landscape. At the average mall, consumers are making shorter visits and visiting fewer stores than in the past; spending levels have plateaued. Experts attribute this to increasing competition from discounters, as well as a decline in leisure time in two-income families.

But some large mall owners remain dubious about the whole entertainment-center idea. Houston-based Hines Interest, which has installed ice-skating rinks at two of its malls, remains wary. “We continue to look at these high-tech entertainment formats, and we continue to be concerned when we go somewhere and see that the customers are overwhelmingly male teenagers,” explains Don McCrory, who runs Hines’s retail division.

Source: The Wall Street Journal, January 23, 1996.

REAL ESTATE FOCUS 6–4

Property Profile: The Legendary Waldorf-Astoria

The Waldorf-Astoria Hotel opened on New York City’s Park Avenue during the Great Depression in 1931. At that time, it was the largest hotel in the world, with 1,852 rooms. From the onset, the Waldorf established itself as an elitist hotel. Until the early 1980s, the Waldorf’s management refused to advertise, relying solely on its clientele’s references as a means of attracting new customers.

In the more difficult and competitive times of the present, the Waldorf has managed to maintain its aura of elegance and distinction. Even in its attempt to serve the convention business, management insists that the Waldorf is not a “convention” hotel. It continues to provide customers with extravagant services. For example, if a guest informs the hotel’s management that relatives are arriving that day for their first visit to New York, the hotel dispatches its limousine to pick up the relatives and sends them a dozen roses and a box of candy. Management considers these services as vital to overturn the notion that “when you turn off the lights and the bed is comfortable, all hotels are the same.”

The Waldorf remains the standard setter and innovator of the upper end of the hotel industry, just as it has since 1931. The Waldorf-Astoria is much more than simply another improvement on land—it is a truly unique business.

Source: U.S. News and World Report, February 13, 1984.

SUMMARY

A major question of concern to real estate investors is what alternative investment opportunities are available in real estate. We have examined this issue from two perspectives. In this chapter, we considered the various types of real properties that can serve as investments, including residential income properties, office buildings, industrial buildings, shopping centers, and hospitality properties. In Chapter 5 we considered the various forms of ownership that can be used to channel investment funds into real estate. The choice of investment mode—the combination of property type and ownership form selected by the individual investor, business, or institution—is a complex decision that has a pronounced effect on the expected return and risk of the investor's asset portfolio. Thus, it is important that property type and ownership form selections be consistent with the investment strategy and objectives of the investor.

KEY TERMS

Community center 182
Condominium complexes 174
Garden apartments 174
High-rise apartment buildings 173
Hoteling 179
Industrial parks 181
Mid-rise apartments 174
Neighborhood or “strip” center 181
Off-price centers 182
Outlet centers 182
Percentage leases 183
Power centers 182
Regional and super-regional centers 182
Specialty shopping centers 182
Urban sprawl 176
Warehouse 180

TEST YOURSELF

Answer the following multiple choice questions:

1. Which of the following is probably the most complex investment?
a. Regional shopping center.
b. Industrial warehouse.
c. Single-tenant office building.
d. Garden-style apartment complexes.

2. Which of the following statements about neighborhood (strip) centers is not true?
a. They are usually anchored by a large chain grocery store or drugstore.
b. The gross leasable area is usually about 50,000 square feet.
c. They are usually anchored by at least two major department stores.
d. Their trade area is typically within a 5- to 10-minute drive of the center.

3. Which of the following is the dominating feature of a power center?
a. It is usually anchored by at least two major department stores.
b. It sells name-brand goods at lower prices by eliminating the wholesale distributor.
c. It is usually anchored by a large chain grocery store or drugstore.
d. It has a high ratio of anchor tenants to smaller (auxiliary) tenants.

4. Garden-style apartments
a. Are typically found in downtown areas.
b. Have a relatively low density of development.
c. Usually include retail establishments such as convenience stores and newsstands.
d. Often have underground parking.

5. Which of the following property types is likely to have the heaviest property management burden?
a. Apartment complex.
b. Industrial warehouse.
c. Single-tenant office building.
d. Retail power center.

6. Which of the following is not a typical advantage of office building investments?
a. Long-term leases reduce the cost of frequently re-leasing space.
b. Most leases are indexed for inflation.
c. Most leases tie the total rent payments to the sales of the tenant’s business.
d. All of the above are advantages of office building investments.

7. Rental housing demand is most influenced by
a. Changes in population.
b. Changes in the number of households.
c. The cost of condominium ownership.
d. The local business cycle.

8. What trend is the most responsible for making many existing office buildings obsolete?
a. The growth of the U.S. service sector over the last several decades.
b. Technological advances in computer networks and telecommunications
c. The increasing use of net leases.
d. The acceleration of urban sprawl.

9. Which property type is generally most resilient to functional obsolescence?
a. Apartment complex.
b. Industrial warehouse.
c. Single-tenant office building.
d. Retail power center.
e. Neighborhood shopping center.

10. Which property type is probably least affected by unexpected increases in inflation?
a. Apartment complex.
b. Industrial warehouse.
c. Single-tenant office building.
d. Hotels.
e. Neighborhood shopping center.

PROBLEMS FOR THOUGHT AND SOLUTION

1. Many analysts argue that the demand for rental housing is, and will be, negatively affected by the aging of the baby boom population. Why? Are there any demographic or sociological trends that may offset, completely or partially, the negative baby boom effect?

2. Some property types, such as industrial warehouses, are perceived to be less risky investments than alternative property types. Does this mean that warehouses are superior investments? Explain why or why not.

3. Compare neighborhood, community, and regional shopping centers on the basis of (1) leading tenant, (2) typical size, and (3) minimum required patron support.

4. Discuss some of the important issues and trends that investors in regional malls should consider in their acquisition and disposition decisions.

INTERNET EXERCISE

Real estate investment trusts often specialize in a particular type of property such as health care facilities or office buildings. The National Association of Real Estate Investment Trusts (NAREIT) REITWatch utility can be used to monitor the performance of each REIT sector, and thus, insight can be gained into the underlying strength of each market segment.

1. Go to the NAREIT home page:

http://www.nareit.com/

and download the latest REIT segmented performance report. Briefly assess the performance of each REIT property type sector. Which property types had the highest returns? Which had the lowest? Finally, compare the segmented returns to those realized on the S&P 500. Which sectors realized similar returns over the most recent reporting period?

ADDITIONAL READINGS

Detailed information on the various property types is contained in

Principles of Real Estate Management. Chicago: Institute of Real Estate Management, 1991.

Pyhrr, Stephen; James R. Cooper; Larry E. Wofford; Steven D. Kapplin; and Paul D. Lapides. Real Estate Investment: Strategy, Analysis, and Decisions, chapters 21–27. New York: John Wiley & Sons, 1989.

John McMahan. Property Development, chapters 7–11. New York: McGraw-Hill Publishing Company, 1989.

FOOTNOTES

 ¹          In a few large metropolitan areas such as New York City, units in many high-rise apartment buildings are privately owned, although they are still typically referred to as apartments.

²           See Principles of Real Estate Management (Chicago: Institute of Real Estate Management, 1991).

³           For a more detailed discussion of these criteria, see Chapter 10 in ibid.

⁴           See Chapter 8 for more detail on typical office lease terms.

⁵           Many of these office market trends are discussed in Emerging Trends in Real Estate (Chicago: Equitable Real Estate Investment Management, Inc., and Real Estate Research Corporation, October 1995 and October 1996).

⁶           For more detail on the requirements of retail tenants, see Chapter 10 in Principles of Real Estate Management (Chicago: Institute of Real Estate Management, 1991).

⁷           Retail leases are discussed in detail in Chapter 8.

⁸           These important issues and trends are discussed in Emerging Trends in Real Estate (Chicago: Equitable Real Estate Investment Management, Inc., and Real Estate Research Corporation, October 1995 and October 1996).