By Christopher M. Wright

Name: Jackson Hsieh Title: U.S. Managing Director of the Real Estate, Lodging & Leisure Group Company: UBS Warburg Age: 41 Experience: Hsieh has been in real estate investment banking since 1987. He joined UBS Warburg in April 2002 from Morgan Stanley.

Real Estate Portfolio recently asked Jackson Hsieh, U.S. Managing Director of the Real Estate, Lodging & Leisure Group at UBS Warburg, to share his thoughts on the capital markets for publicly traded real estate and the economy as a whole.

Portfolio: What do you expect from the economy in 2003?
Hsieh: I expect continued weakness through 2003. Nothing catastrophic, but the recovery will take longer than people generally are thinking. Corporations are still rationalizing overhead. They're not spending capital and the mindset is generally defensive.

I spend a considerable amount of time focusing on the hotel industry, which offers a great picture into the general state of the economy. Given that hotels run on a daily lease basis, hoteliers either sell a room on any given night or that inventory, or particular revenue opportunity, is lost.

The travel demand forecast continues to be weak, with most hotel companies revising operating assumptions downward through 2003. The urban upscale hotel sector tends to be a leading indicator for other commercial real estate asset classes—for example, office and industrial.

Portfolio: It sounds like your picture of real estate is pretty grim for the year.
Hsieh: Grim is too harsh a description. However, real estate is a lagging indicator of the economy. While most economists are forecasting an economic recovery in 2003, the real estate markets will have to deal with significant overcapacity. Most corporations are downsizing operations and sitting on substantial amounts of subleased or vacant space. The job growth side of the economic equation will need to grow into the excess commercial space that is on the market.

Portfolio: What's your view of real estate capital markets going forward?
Hsieh: On the debt side, the secured CMBS (commercial mortgage backed securities) market has developed into a significant market, representing 20 percent of the $1.7 trillion real estate debt market. The CMBS market is liquid from an issuer's point of view, with strong institutional demand for the ultimate securities that are issued backed by the pools of diversified mortgage collateral. This has resulted in lower borrowing costs, higher leverage and ease of borrowing by owners of small and large commercial properties.

The corporate unsecured bond market for real estate companies has also flourished due to the perception of major event risk, accounting restatements, fraud, and inadequate corporate governance in the broader, non-real estate corporate world. This has resulted in a significant widening of bond spreads for large bellwether investment-grade corporations, across an array of industries.

For example, a BBB-rated industrial REIT could issue 10-year paper at a spread of 175 basis points (bps) above comparable maturity treasuries versus a similar BBB industrial manufacturing or logistics company that might issue the same bond at 275 to 300 bps over treasuries. Investors perceive real estate companies to be more insulated from deteriorating credit quality and rating agency downgrades.

Portfolio: How about the equity market?
Hsieh: The public equity market through 2002 was extremely volatile. Investors who bought or held stock in non-real estate companies lost significant money, including those which invested in index funds. The NAREIT Equity REIT Index has outperformed most of the major indices—Dow, S&P 500, Russell 2000. And why is that? Yield. Investors want yield, some share price upside, but low volatility.

REITs are a great answer to this demand, witnessed by the numerous closed-end REIT funds that raised approximately $3 billion during the past 12 months. REITs generate about 6 percent to 7 percent in dividend yields, and, assuming modest growth in funds from operations in 2003 and 2004, they will likely grow share prices in the 3 percent to 5 percent range, resulting in a 9 percent to 12 percent total return.

The risk facing the real estate equities market begins once institutional investors believe the economic recovery is underway and the broader stock market is expected to generate more growth in earnings per share than real estate stocks. At that point, there likely will be a significant rotation out of REIT equities and into the broader corporate equities market. This ultimately will result in lower share prices for REITs.

Portfolio: What else are we likely to see in the real estate capital markets this year?
Hsieh: We're in a unique environment right now—historically low interest rates, significant borrower liquidity in the mortgage market and a cadre of institutional investors seeking direct investment in core real estate assets. I would not be surprised if we saw continued consolidation, leveraged buyouts or significant recapitalizations from some of the smaller market cap REITs. There is no shortage of equity interest in direct real estate ownership from institutions.

Portfolio: What other non-domestic institutional forms of equity are you seeing?
Hsieh: We are seeing significant interest on behalf of German open-end funds to invest in the U.S., prompted by a recent change in German law, which enables new open-end funds to invest in real estate outside of Europe. They primarily are focused on class A office buildings.

The other interest we see for U.S. real estate is from Australia. There have been three major Australian Listed Property Trusts floated in Australia that principally own U.S. real estate—Westfield America, Lend Lease U.S. Office Trust and the Macquarie-ProLogis Industrial Trust. In addition, there are a couple of Australian IPOs of U.S. assets being contemplated.