According to Emerging Trends in Real Estate 2002, published by Lend Lease Real Estate Investments and Pricewaterhouse-Coopers, 2002 should mark the nadir of a sudden correction in U.S. real estate markets, ushering in a modest growth phase for the 2003-2005 period that closely tracks the economic turnaround. Equilibrium will be tested, but, as noted, “overleasing occurred, not overbuilding.” Expect total unleveraged real estate returns for 2002 to reflect continued strong cash flows from established, well-leased properties combined with flat value growth or even marginal value decline. That translates into performance, ranging from 7 to 9 percent. “Appreciation, you are the weakest link,” quipped a portfolio manager, voicing a common concern. REITs can expect a choppy year, with cash-flow growth crimped, but basic dividends remain high. Long-in-the-tooth opportunity funds, especially those employing liberal leverage strategies, will get clipped – possibly worse if they’re forced to cash out in hiccupping markets. Opportunistic investors, however, should find deals in the market dip. Emerging Trends suggests that 2002 could be the best year to buy since the 1997-98 period. At the same time, rental rates and pricing should settle back into the range of replacement cost, allowing properties to chalk up solid income gains as old leases roll over.Most importantly, however, 2002 promises to be a critical time for defining real estate’s future position in investors’ portfolios. How performance behaves will determine “whether we’ve finally grown up. Are we legit or not?” notes a prominent pension fund real estate advisor. The stigma of the early-1990s debacle won’t be easily expunged, but if portfolio cash flows hold firm – and fundamentals suggest they will – strong income yields should draw increased interest from capital sources for equity and debt investments.A number of Emerging Trends interviewees focused on the economy and emphasize that real estate appears relatively well positioned to weather a recession without too much self-inflicted damage. Here’s why:• Markets have been in equilibrium. Office vacancies are climbing, but from extremely robust occupancy levels. Apartment and warehouse markets have been solid, and while lessening demand could cut into their income, their staying power should ride out any economic decline. Hotel profitability was at record levels pre-September 11, but will have to weather the fallout into 2002. The recession will also hit retail.• Attractive risk-return profile. “Real estate is a bargain except for the fear about the economy,” notes the Emerging Trends report.• Supply is under relative control. Lenders have carefully restrained developers – especially in downtown office and hotel markets. One interviewee notes, “We needed a recession to make sure construction stayed under control. It was getting going again, so it was time to be brought up short. Long run, this is good.”• Lease structures offer protection. Even though “the excess has been taken out of the market,” net operating incomes can still grow. “Real estate provides stability – high-credit leases bridge the gap of uncertainty,” notes the report’s interviewees.• Low interest rates help protect values. Cash-strapped investors forcing buildings onto the market at bargain pricing are few and far between, and delinquency rates have stayed down. Most owners will benefit from the option to refinance at highly attractive spreads to healthy property yields – thanks to steadily dropping interest rates.Linda K. Monroe ([email protected]) is editorial director at Buildings magazine.