Imagine a real estate industry where the focus is not on deal-making.

It’s hard, I know, but according to KPMG LLP’s national real estate practice, the industry is headed in that direction.

The firm’s 1999 Outlook Industry Forecast provides a great deal of food for thought, especially for real estate professionals who have never worked in another industry. And for those in other industries, this maturation of the real estate industry may serve as an object lesson in getting back to the basics of good management practices and revenue drivers.

A portion of the forecast includes the same information we all have heard from real estate service firms across the country: fundamentals are strong; growth will slow, but remain positive.

"With interest rates down and management focusing on a variety of profit-improvement strategies, dividend yields on public real estate investments should continue to beat the bond market this yea, and should be in the 7 to 8 percent range, with an expected total return (including dividends and appreciation) to be in the range of 9 to 13 percent," said Ray Milnes, national industry director of KPMG's national real estate practice.

Milnes added that real estate fundamentals will remain sound in 1999. With share prices for real estate companies currently below the net value of their assets, investments in this sector are projected to be solid and may prove to be very attractive, he said.

The rest of the report deals with issues long recognized by other U.S. industries but never focused upon by the real-estate community.

After a six-year recovery period, the real estate industry seemingly reached its cyclical peak last year. In the past, such a peak has resulted in a wave of "spec" development, swiftly followed by a downward spiral in property values. I painfully site the dreaded ‘80s, especially in my native Dallas.

"There is not projected to be the dramatic reduction in values that have been typical of past cyclical peaks because we now have more lender discipline relative to new development activity," Milnes said. "For example, we are not likely to see lenders making high loan-to-value development loans for 'spec' buildings any time soon. Instead, companies will have to bring pre-leasing to the table to secure financing at a reasonable price."

In other words, money won’t be handed out by banks like lollipops at the drive-up teller window. In addition, some investors have about had it with Wall Street’s Big Adventure this year.

"Today, the public markets help damper the ability to go out and over-buy and over-build," says Richard Smith, National Director of REIT services. "The end result is better management of existing portfolios."

And Milnes said the institutional investor will move away from the investment for a quick "pop" and look for a strategy whereby funds will be allocated for long-term portfolio stability.

"In a maturing industry with controlled development activity, the risk that real estate values will suffer will be much more limited," Milnes said. "Real estate continues to be a good hedge for institutional investors. We anticipate that they will see real estate as a sustained business that is maturing."

Here’s where it gets really interesting.

Since the acquisition market will not be hot, REITs and other property owners will have to develop their revenue streams and strengthen their bottom lines through traditional management strategies.

KPMG takes it even further than that. REITs basically will become utilities.

"The mid-1990s presented a secular transition for REITs as the market came out of a tremendously undervalued situation. The public capital markets, fueled by arbitrage, gave the industry a tremendous boost," said Carl Kane, national director of real estate and capital markets consulting for KPMG. "With the acquisition climate frigid in 1998, REIT management looked toward bottom-line growth through process improvements, technology improvements, and value-added services for customers. In other words, new ways to create stable cash flow and value.

"Real estate companies cannot drive income growth just from the top line anymore," Kane added. "REITs will stabilize in 1999 and come to be viewed far and away as a utility-type investment. In essence, we'll come to terms with the reality of what a REIT truly is: ‘yield plus,’ with a little equity thrown in."

If you’re new to REITs and don’t buy the theory that FFO is similar to utility company dividend payments, keep reading. "If one looks at how REITs are priced, it's much like a utility now," said Frank Nardozza, national director of KPMG's hospitality practice. "Instead of using high double-digit earnings multiples to price shares as we did one year ago, REITs are now priced using more modest multiples in anticipation of slowed earnings growth and more stable future dividend yields.

"Because REITs can no longer rely on earnings growth by going out and acquiring new properties, management is now focusing on accounting systems and other technology solutions to reduce and/or eliminate costs," Nardozza added. "Even apartment REITs are finding ways to better manage renters by viewing them as customers to promote brand allegiance. The hospitality sector fits this model to a tee."

Enter traditional management strategies for efficient operations and improved corporate performance. According to KPMG, real estate companies will continue to restructure. They will move away from deal-oriented, silo-type management and toward a management business model that integrates the organization to reduce costs and increase efficiencies. This is sorely needed in the industry, where overhead no including benefits and pay runs a shocking $30,000 to $40,000 per employee.

"The key to reducing this inordinately high cost per worker is to step out of paradigms and focus on collaboration between departments," Kane said.

Published: January 12, 1999

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