Commercial real estate's upbeat outlook.

The future still looks very positive for the commercial real estate business. Some trends call for business owners to rethink their strategies and corporate organization to capitalize on emerging opportunities.

It seems to be the best of times in the real estate industry - the moon, planets

and stars must be aligned right. Supply and demand are in equilibrium, vacancy rates generally are declining, rental rates are increasing and real estate capital is readily available. Overbuilding is a concern, but more development companies today are publicly held and have access to more data; and strong organizations are subject to market discipline - companies that build indiscriminately may see their stock prices decline.

This is an opportune time, then, to evaluate your organization, its position in the real estate industry and its strategic objectives. The following are some of the trends to consider in your strategic planning:

The integrated real estate company

As real estate companies become larger and public, and corporate America moves to more actively manage its real estate assets, some real estate companies may need to restructure to meet the needs and expectations of the corporate market. For example, the largest corporations may prefer to deal with a single buyer or a small number of buyers in negotiating sales of large portfolios of corporate assets located in various markets. Only the largest real estate companies, real estate investment trusts (REITs), pension funds and other investors may meet this corporate criteria. Similarly, only large national brokers and property management companies and other service providers may have the capabilities and resources to service the corporate market. The advantages of size are a key reason for the continuing wave of mergers and acquisitions in the real estate industry and the emergence of more large national real estate organizations.

In the future, as the real estate industry continues to consolidate, a new model will emerge: the integrated real estate company. Thus far, mergers in the real estate industry generally have been among organizations in similar lines of business; for example, large owners of investment properties have merged with other such owners, commercial brokers with other such brokers and so on. Some organizations have begun to diversify; for example, by expanding from the residential into the commercial sector or by launching non-real estate services. But this is only the beginning. As the real estate market continues to evolve, large, fully integrated companies will be formed to provide a full range of real estate services to corporate and other clients, both in the United States and international markets.

The fully integrated company will include an owner of operating real estate assets (which could be structured as a REIT), a development company (structured as a "C" or "S" corporation or Limited Liability Company), a "pipeline" company that will acquire portfolios of properties (and will be structured like the development entity), a services company, a finance entity and a subsidiary or strategic partner that operates in international markets. Despite the trend toward large, integrated companies, small real estate companies will continue to find niche opportunities in providing services to companies, businesses and other organizations.

With the continuing evolution of the real estate market and the growing opportunities in the corporate sector, real estate companies need to do strategic planning. This planning should include deciding on their goals and objectives, their form of organization, their target markets and other strategic issues. With planning and foresight, companies can adapt and grow in a fast-changing market.

Entity financing

Real estate companies today have more flexibility in the use of financing, through entity financing, traditional project financing or hybrids of the two. Furthermore, they can select between equity and debt financing, and between public and private markets. Many real estate companies have investment-grade ratings to access cheaper debt.

To take full advantage of the opportunities created by this highly flexible financing matrix, real estate companies need to understand the advantages and limitations of entity and project financing. Among other benefits, entity financing provides greater diversification and, usually, greater liquidity. Investors can buy the stock of a public real estate company, or interests in a private company, or they can invest in the company's debt securities. By investing at the entity level, rather than in specific projects, investors gain entry into all of the markets in which the company is developing projects or acquiring properties as well as participation in the future upside.

With project financing, entrepreneurs and investors are limited to investing in specific projects or assets. This means obtaining financing and negotiating terms each and every time a project is developed or a property is acquired. This can be a management-intensive and time-consuming process. Nevertheless, project financing has its advantages. It could be nonrecourse without cross-collateral, and therefore, self-contained. It may facilitate off-balance sheet financing to contain risk or achieve other common objectives; for example, a company may use it to segment a troubled property from the rest of its portfolio while it implements a plan to restructure and restabilize the property. And once a project is completed, the developer and its partners can part company if they choose.

While project financing will continue to have its place, the trend is toward entity financing, and that raises management issues. Instead of viewing real estate simply as a collection of assets, management must take a business approach with a focus on strategic planning, operations, technology and raising capital, including the use of entity financing. Companies with superior management will have a competitive edge in accessing capital.

Immigration

In the 1990s, nearly 900,000 immigrants arrived in the United States each year - half of them from Latin America and one-fourth from Asia. Immigrants have accounted for nearly one-third of overall population growth. In fact, immigration will drive population growth well into the 21st century. The U.S. population is expected to increase from 263 million in 1995 to 387 million in 2050. The National Academy of Sciences notes that if immigration continues at current levels, it will account for nearly two-thirds of projected population growth in the first half of the 21st century, i.e., of the expected increase of 124 million, immigrants and their descendants will account for 80 million.

As consumers - homebuyers and owners, tenants in rental housing and buyers of goods and services - immigrants will constitute an increasingly larger market for home builders, owners and developers of multifamily housing, retailers and retail developers. As owners of start-up businesses, immigrants will create demand for office and industrial space and for real estate-related services. And more immigrants have accumulated the wealth to begin making investments in the United States, including the commercial-property markets. Finally, like corporate America generally, real estate companies in the future will recruit more of their employees and managers from the immigrant population.

Developers, home builders, property owners and others in the real estate industry will see more of their future tenants, buyers, customers, investors, business partners, managers and employees coming from the nation's rapidly growing immigrant population. Developers and others need to take a look at the markets where they do business, their customer base, product and service lines, capital requirements and human resources needs, and start thinking of how they can take advantage of the opportunities created by the growth in the immigrant population.

Energy deregulation

With the cost of energy being one of the largest line-item expenses in operating buildings, corporations and businesses, as well as property investors and managers, have a vital interest in the effort of a growing number of states to deregulate the sale of electric power, open the market to competition and substantially reduce costs to consumers. Some high-cost states such as California expect their energy costs to drop 15 percent to 30 percent over a three- to five-year period beginning in 1998.

The advent of deregulation has raised questions about how a competitive market will work. But this much is certain: To take full advantage of the opportunities created by deregulation, companies and businesses need to begin immediately to develop plans and strategies for determining their energy needs, selecting providers, negotiating rates, ensuring reliable service and monitoring and managing their use of electricity.

Niche markets

* Assisted living. In the rapidly growing seniors housing industry, assisted living provides "housing, supportive services, personalized assistance and [limited] health care" to relatively healthy seniors over the age of 80. This segment of the industry has become a major focus among aging seniors, senior care companies, health insurers, state legislators, as well as, more recently, developers, commercial lenders, investment banks, venture capitalists and opportunity funds.

The assisted living industry bears several striking similarities to the hospitality industry. As a result, hospitality companies that carefully perform their due diligence should find opportunities in new construction, conversion/renovation, management contracts, franchising, as well as real estate opportunities such as sale/lease-backs with REITs, synthetic leases, real estate holding company spin-offs and other financing vehicles.

* Health care. Although real estate can constitute as much as 50 percent of the total net assets of a typical health care services system, it has long been an overlooked and underutilized asset on the balance sheets of health care providers. Under traditional cost-based accounting, providers treated investments in plant, equipment and other real estate simply as a cost of doing business. However, increasing pressures to reduce costs are prompting providers to recognize the importance of real estate as a strategic asset. As a result, they are starting to take an aggressive approach to its management.

More providers, usually with the help of outside consultants, are developing strategic real estate plans. While such plans may differ in their particulars, providers generally have common goals. Among them are to reduce costs through such measures as more efficient use of space; to unlock hidden asset values by identifying surplus real estate assets and moving them off the balance sheet and by utilizing off-balance sheet financing of core real estate assets; and to convert illiquid real estate assets into cash through sales, sale leasebacks and off-balance-sheet financings.

These strategic objectives can be achieved through comprehensive diagnostic reviews of real estate operations that identify opportunities to reduce costs and manage operations more efficiently, as well as through off-balance-sheet financing structures including sale-leasebacks and synthetic leases. In the highly competitive health care business, smart management of its real estate could give a health care provider a critical competitive advantage.

* Urban entertainment destinations. Like the regional malls of the 1970s and the festival marketplaces of the 1980s, the urban entertainment destination (UED) of the 1990s, aims to revitalize the retailing business by attracting customers into stores, encouraging them to spend and drawing them back again and again. With increased competition for the consumer dollar among traditional shopping centers, power centers, discount stores, catalogue retailers, cable shopping channels, the Internet and other forms of retailing, urban entertainment destinations are designed to gain an edge by integrating entertainment with shopping and dining. Consumers come to these centers not only to buy goods and services but also to temporarily put aside high-pressure, stressful lifestyles and enjoy precious moments of leisure. UEDs are intended to meet that need by creating an atmosphere of discovery, novelty, excitement and fun.

There is a perception that only the largest entertainment companies have the resources, knowledge and experience to finance the development of such projects, attract outside investors and lenders, and produce a steady stream of new entertainment products that will attract not only first-time but also repeat visitors. Smaller entertainment companies and developers clearly cannot expect to compete with the giants but they may find niche opportunities in developing smaller-scale entertainment destinations. The challenge is to come up with original ideas that have broad market appeal.

Repositioning underperforming properties

Although commercial property markets generally are improving, some properties continue to underperform because of physical problems, including poor architectural configuration, site/access issues or market-related problems such as poor image. By developing strategic plans to reposition problem real estate assets, owners have opportunities to improve the image of these assets, attract tenants and increase property values.

Outlook

In today's fast-changing, highly competitive marketplace, companies must be prepared to make timely, informed decisions to take advantage of strategic opportunities and gain an edge. Otherwise, they could find themselves constantly on the defensive, reacting to structural shifts in the economy or real estate markets, changes in capital availability, new competitive challenges and other strategic concerns.

To control its destiny in a complex and uncertain business environment, a company needs to develop a strategic business plan. It details how the company will accomplish the goals and objectives of its owners, whether they are shareholders of a Fortune 500 company or partners of a privately owned, closely held business. The goals may include increasing shareholder value, entering new markets, completing a merger or acquisition, increasing investment yields or investing in new information systems.

For certain the planning process is more complex and more demanding than during the real estate boom of the late 1980s, when many developers and builders were so busy producing new product that planning was almost an afterthought. But if there is a lesson to be learned from the real estate recession of the early 1990s and the emergence of a more competitive marketplace, it is that a thoughtful, well-reasoned strategic business plan is critical to a company's success.

Stan Ross is managing partner with E&Y Kenneth Leventhal Real Estate Group in Los Angeles.