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~e Appraisal Journal; Oct 1989; 57,4; ABIIINFORM Global

5. 466

Howard C. Gelbtuch, MAl

The World of Commercial

Real Estate: A Look at the
Past 15 Years

J...ooking at the world or commercial real estate since 1975 may help clarify todaY'1i
situation and provide some insight Into the ruture. The author suggests that pc:rbaps
a new approach to value is needed, one that reneds the curreut worldwide insti­
tutional demand ror high quality U.S. real estate.

M any real estate professionals 1975-1979

have now grown accustomed to
seeing 15% to 20% office vacancy
rates, six months or more of free
rent on a typical five-year lease,
internal rates of return for trophy
properties in single digits, and in­
explicably low capitalization rates
for regional malls. However. just
a decade ago, prices of Manhattan
office buildings were one tenth of
what they are today, the prime rate
was 15% and rising, and dis­
counted cash flow (DCF) analysis
was just starting to be used for
valuing mu1titenant properties. A
look at what has happened in the
world of commercial real estate
since 1975 may help clarify the sit­
uation we are in today and provide
some insight into what to expect in
the future.
In 1975, the prime rate was aver­
aging about 8%, and inflation was
advancing at an arumal rate of about
6%. Real estate investment trusts
(REITs) had already boomed and
busted; New York City was in the
doldrums. Manhattan's Chrysler
Building, architecturally distin­
guished and occupying a prime lo­
cation across from Grand Central
Station, a key terminus for subur­
ban commuters, was in danger of
foreclosure, as was the Commo­
dore Hotel across the street. Dis­
count departn1ent stores were con­
tinuing to proliferate as they had
been doing since the start of the
decade. Because inflation was not
perceived ac; threatening, invest­
ment properties were frequently

Howard C. Gelbtudl, MAl, is senior vice president of Integrated Resources. Inc., for which be
founded and heads the real cstate: eVllluatiun department . He holds a BS in finance from New yon.
University and an MBA in real estate from The Bernard M. Baruch College of The City University
of New York. He has taught lit Adelphi, Hofstra, and New York Universities and has lectured for
the Amcrican Institute of Real Estate Appnlisen;.

466

~eproduced with permisSion of the copyright owner. Further reproduction prohibited without permission.
 valued by applying an overall cap~
italizationrate abstracted from
comparable sales to a property's
stabilized annual net operating in­
come, or use of a gross rent mul­
tipJier (GRM). Appraisers were still
reluctant to make assumptions about
the future. Their thinking reflected
the following excerpt from a Jan­
uary 1974 Appraisal Journal article.
The most significant factors for
the determination of yield on the
equity investment are usually the
duration of the holding period and
the net reversion to equity . Ob­
viously, these are imponderables
at the time of appraisal. They will
be the result of management de­
cisions which cannot be made un­
til specific opportunities to sell
occur at various specific times in
the future. Because the number
of possible combinations is infi­
nite at the time of appraisal, it
follows that the appraiser has no
reliable way to predict them.
This is the dilemma with re­
gard to the employment of capi­
talization as an independent ap­
proach to value. Future benefits
of ownership cannot be dis­
counted to present worth at a rate
of interest which will attract pur­
chase capital until the interest rate
is known. The interest rate can­
not be known until unpredictable
future decisions are made. I
In 1976, the United States cel­
ebrated its bicentennial, and Jimmy
Carter and Walter Mondale barely
defeated Gerald Ford and Robert
Dole. Kmart, fonnerly S. S. Kresge
and now the nation's largest dis­
count retailer, purchased a block
of defunct W. T. Grant discount
department stores throughout the
country. Late in the year, Olympia
& York, the Canadian conglom­
erate, showed uncanny foresight by
purchasing nine prime Manhattan
office buildings for only $320 mil­
I. L. W. Ellwood, MAll Rights to Ful\JI'C Benefits,~ Th~ Appraisal Journal (Jll/luary 1974): 40.
2. Edwatd S. Gordon Company, Inc. , TM Gordon Office Marut Rt!port Midtown Manhi11UJ11 &
Downtown Manhartan (New York Edward S. Gordon Company, Inc.), October 1988.
Gelbtuch: The World of Commercial Real Estate
teproduced with permission of the copyright owner. Further reproduction prohibited without permission.
lion or $31 per square foot. Al­
though the price was not unusual
(see Table 1), it took an outsider
to recognize value. The typical The end of 1977
American investor could not see the marked the
forest for the trees. beginning of a five­
The end of 1977 marked the be­ year boom in real
ginning of a five-year boom in rea1 estate. Total
estate. Total returns outperfonned returns
the stock market through the end outperfonned the
of 1982. stock market
By the end of 1978, the prime through the end of
rate, ,\,hich began the year at 8% 1982 .
hit 114%, and a five-year period
characterized by high inflation and
low vacancies began. Mortgage­
equity capitalization, which allows
for the consideration of both mort­
gage tenns and equity yields in the
detennination of capitalization rates,
finally gained more acceptance as
interest rate volatility increased.
This was almost 20 years after its
introduction by L. W. Ellwood.
Even in 1978, however, the rum­
blings of discontent could be. heard
as analysts questioned the reliabil­
ity of extracting equity return re­
quirements by breaking down cap­
italization rates.
Although 1979 was a turbulent
year for the United States because
of the Iranian hostage situation, the
Three Mile Island disaster, gaso·
line rationing, and the Chrysler bail..
out, it was not a bad year for own­
ers of real estate.
Rents skyrocketed between 1979
and 1981. In Manhattan, for ex­
ample, the largest office market in
the country, midtown rents soared
by 178% from $14.37 per square
foot in December 1978 to $40.00
per square foot in December 1981;
downtown, rents rose 139% from
$11.64 per square foot to $27.86
per square foot. 2
~e prime rate went ~m
114% at the start of 1979 to 15 4%
467
11
 TABLE] Representative ]979 and 1980 Manhattan Office Building Sales
Rentable Area Price per
Property Address (sq. ft.) Price Square Foot
I 315 Fifth Ave. 45,()(X) $1,600,000 $36
2 347 Fifth Ave. 101,890 2,600,000 26
2A 347 Fifth Ave. 101,890 . 3,100,000 30
3 300 Madison Ave. 500,()(X) 14,000,000 28
4 330 Madison Ave. 719,B% 35,000,000 49
5 347 Madison Ave. 186,()(X) 11,900,000 64
6 530 Fifth Ave. 415,303 32,000,000 77
7 161 East 42nd St. 450,150 24,547,354 S5
8 660 Madison Ave. 433,151 26,396,670 61
9 375 Park Ave. 640,000 86,460,000 135
10 1211 Ave. Amer. 1,6IJ7,439 136,331,126 85
11 9O-Dl John St. 394,663 12,670,000 32
12 38-42 Exchange PI. 208,000 6,800,000 33
13 16-26 Exchange PI. 612,000 28,()OO,000 46
14 25 Broadway 686,708 16,204,660 24
15 1 Broadway 155,000 5,000,000 32
16 25-33 Broad St. 446,670 15,321,428 34
17 30 Broad St. 346,900 3,875,446 II
18 83 Maiden Lane 129,400 4,100,000 32

at I the beginning of 1980, and i or incomes anticipated to system­

2<rz% at the start of 1981, almost
reaching its all-time high.
1980-1984
Pension fund sponsors, recogniz­
ing that they held only 2% to 3%
of their assets in real estate (still
more or less true today) and wish­
ing to diversify because of Em­
ployment Retirement Income Se­
curity Act (ERISA) concerns, began
investing in real estate in earnest
around 1980.
By 1981, a combination of high
inflation and low vacancies, which
resulted in sharply higher rents,
more than tripled the value of the
Olympia & York purchase _made
just five years previously to over
$1 billion.
Until this time, the Ellwood
method genera1ly continued to work
well and its use was widespread.
But, because it was designed for
the ana1ysis of properties with either
stable (or stabilized) income streams
atically increase or decrease, its
applicability in times of widely
varying inflationary expectations
became subject to closer scrutiny.
The investment community ulti·
mately determined that a DCF
analysis, facilitated by the wide­
spread use of computer software
capable of analyzing properties on
a lease-by-Iease basis, was more
appropriate. Just ten years earlier,
a computer program described in
The Appraisal Journal was tar­
geted to a market of no more than
50 or 100 users in its flI'St two
years. 3
The then widespread perception
of inflation is amply illustrated by
an article by James P. Koelsch that
appeared at that time.
Because real estate prices are in­
fluenced by inflation. which may
change both rents and property
values, it seems reasonable to
presume that the average investor
considers the effects of inflation
when purchasing property. This

3. M . B. Hodges, Jr., "Compuler Progress in Valuation of Income Properties," Tile Appraisal

JOllrnal (Januery 1971): 16.

468 The Appraisal Journal, October 1989

,eproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 is supported by the fact that many
investors purchase property that
provides little or no cash flow to
the equity position, anticipating
the prospect of future increases in
rents and/or property values.
Therefore, when a real estate ap­
praiser values real estate, he(she)
should consider whether or not the
subject propeny has expectations
of increasing rents and value sim­
ilar to those of comparable
properties. 4
Note how expectations changed
from depreciation to appreciation.
Peter F. Korpacz and Mark I. Roth
said it more directly.
The direct capitalization tech­
nique used in the income ap­
proach is ineffective in today's
market, because it relied on the
capitalization of a single net op­
erating income (NOI) estimate
(based on a first-year projection),
an average for a balding period,
or a stabilized estimate. So many
differences in growth prospects
currently exist from one property
to another that an overall rate may
not apply to more than one. Fur­
theODOre, overall rates derived
from a band of investment anal­
ysis are mostly irrelevant, since
mortgage financing is either not
available or is based on compli­
cated participation (kicker)
formulas.
The direct capitalization tech­
nique no longer reflects the think­
ing of today's real estate market
participants. Buyers are not in­
terested in a contrived single NOl
reflecting average or stabilized
income expectancy, but they are
keenly interested in how much
income they are going to receive
and when they are going to re­
ceive it. The underlying principle
of the income approach-"value
is the present worth of future
benefits"-is more valid than
ever. The appraiser, however,
4. James P. Koelsch, "Discounting Projected Cash Flows." Tht! Apprai.saJ Journal (October 1981):
524.
S. Peter 1-'. Korpacz and Mark 1. Roth. -Changing Emphasis in Appraisal Techniques: The Tran­
sition to Discounted Cash Row," T"~ Appraisal Journnl (January 1983): 23.
Gelbtuch: The World of CommerCial R~al Estate
Reproduced with permission of the copyright owner. Further reproduction prohibited without permiSSion.
cannot accurately and convinc­
ingly reflect this in the c~pitaliza­
tion of a single NOI estimate. s
Meanwhile, on the retail scene,
a tax cut in 1982 resulted in in­
creased disposable income for con­ In 1983,
sumers. That year also marked the unprecedented
acceptance of "festival" shopping suburban growth
centers such as Fanueil Hall in and development
Boston, Harborplace in BaJtimore, began. In 1984, the
and the South Street Seaport in New construction boom
York, among others developed by began 10 take its
the Rouse Company. During 1982, toll.
the prime rate went back down to
15£% and settled in the 11 % range
for most of 1983 and 1984.
Unprecedented suburban growth
and, unfortunately, unprecedented
development began in 1983, along
with spirited construction of large
suburnan office projects and the
growth of strip shopping centers.
The next generation of regional
malls with three, four, and even five
anchors superseded older regionals
with only two anchors-;-fre­
quently J .C. Penney and Sears. The
demand for office buildings, how­
ever, outweighed that for malls.
A four-year heyday for syndi­
cators began in 1983, as sales of
real estate limited partnerships
soared. By this time, the vaJue of
some of the individual buildings in
the 1976 Olympia & York pur­
chase exceeded the original $320
million paid for the entire portfo­
lio. These properties were valued
at over $2 billion in a 1984
appraisal.
In 1984, the year of the Reagan­
Bush landslide, the recent boom in
construction began taking its toll.
As suppty exceeded demand, rents
leveled off, or in many cities they
declined. Midtown Manhattan
rentals stabilized at approximately
$40 per square foot, where they re­
main today.
469
 In the meantime, the bull market
for stocks that started in 1982 re­
mained strong. Stocks continued
to outperfonn real estate as inves­
tor, not tenant, demand held
ground.
1985-1988
At the beginning of 1985, the J>Iit!le
rate was holding steady at 1<n%.
Office construction Significantly, between April of
peaked in 1985. 1985 and July of 1986, mortgage
During 1985 and rates declined by about 200 basis
1986, there was points, resulting in dramatically
still tremendous lower yield requirements and cor­
demand for real respondingly higher building prices.
estate from Office construction peaked in
syndicators, 1985. During 1985 and 1986,
pension funds, aM however, there was still tremen­
the Japanese. dous demand for real estate from
syndicators, pension funds. and
now, the Japanese. At the same
time, most institutional grade
properties were owned by life in­
surance companies and pension
fund sponsors who were finan­
cially strong and reluctant to selJ .
Why? Because they believed that
they could weather the surplus of
vacant space and were afraid that
high inflation would return and
cause values to soar once again as
they did in the early 198Os.
Hence, 1986 was the beginning
of the era of asset markets (the
supply and demand for buildings
by investors) no longer tracking
space markets (the supply and de­
mand for space by tenants). Values
or prices no longer tracked rents,
which is why the value of Man­
hattan office buildings has contin­
ued to increase even thoug}}' rents
have remained level since 1984.
Two significant economic events
occurred in 1986. One was the Tax
Refonn Act, which attempted to
place economics over tax shelter as
the motivation for most domestic
taxable investors to purchase real
6. Salomon Brothers, Inc., Bond·Marlut R~s~aTch: Real EslOl~. Japanu~ Jnv~"'~nl in V.S.
E~'al~: An Vpda!e (New York: Salomon Brothen;, Inc., February 1988).
470
~eproduced with permission of the copyright owner. Further reproduction prohibited without permission.
estate. Second was the collapse of
oil prices, which caused many
companies to layoff workers and
reduce their office space needs.
Also significant in 1986 was the
increased presence of the Japanese
as buyers of American real estate.
It is important to keep in mind that
there has almost always been for­
eign investment in U.S. real es­
tate-the Dutch and the British, for
example. What caused the Japa­
nese to suddenly become inter­
ested in U.S. real estate was a boom
in Tokyo real estate. Prices of many
properties there roughly doubled in
1986 to $4,000 per square foot for
a few prime buildings. Compare
that with the prices they paid for
U.S . real estate that year (see Ta­
ble 2).
All told, the Japanese had
invested:
Investment Total
Per Year Investrnent6
Year ($ billion) ($ billion)
Prior to
J986 1.5
1986 4.8 6.3
1987 6.8 13. 1
1988
estimate 7-10 20-23
Despite the building boom be­
gun in 1983 and 1984, many mar­
kets still held their own. Detroit and
the central business districts of
Boston and New York, for exam­
ple, all began 1987 with office va­
cancy rates of under 10%.
In 1987, the year the stock mar­
ket crashed, the Japanese began
spreading out from New York, Los
Angeles, and Hawaii to the rest of
the country, spurring the globali­
zation of real estate prices as other
cities attracted the attention of for­
eign investors. Table 3 shows how
much more was paid per square foot
in 1987 as compared with 1986.
R~al
The Appraisal Journal, October 1989
 TABLE 2 Representative 1~ Purchases by Japanese Inyestors
Price per
Price Square Foot
City Property ($ miUiOD) ($)
Los Angeles Arco Tower 600 260
New York Exxon Building 610 295
New York Tower 49 301 500
New York ABC Building 175 365
Los Angeles Two Century City Buildings 230 200
Los Angeles Chase Plaza ]~ 290
lAs Angeles Reliance Building 145 320
Average $319

TABLE J Representative 1987 Purcbases by Japanese Investors

Price Price per Square Foot
City Property ($ million) ($)
New York 399 Park Ave. 670 500
New York 666 Fifth Ave. 500 450
Maui Hyatt Regency 319 400,000
(price per room)
Washington, D.C. US News and 80 480
World Report
New York 919 Third Ave. 325 285
Average $429*
*ExcIudes Hyatt Regency

Office construction began lev­ cisco, vacancies decreased from

eling off in 1987, with a 30% de­
crease from 1986. Net office ab­
sorption increased by 6% over 1986
to 120 million square feet.
Office construction decreased
again in 1988, and the suburbs
garnered more than their fair share
of absorption. A Salomon Brothers
Real Estate Research Group sur­
vey published that year found in­
stitutional investors bullish over the
long term on real estate.? The
prognosis appeared correct as sev­
eral cities reported record office
leasing activity. In downtown Chi­
cago, for example, 9.3 million
square feet of space was leased,
exceeding the 1987 level by 5%.
In New York, more than double the
amount of space was leased in No­
vember and December than in the
prior two months. In San ' Fran­
almost 19% at the end of 1987 to
under 16% by year-end 1988. And
in Washington, D.C., even though
1988 leasing activity was virtually
identical to that of 1987, rents in­
creased by 10%.8 Japanese inves­
tors continued to branch out farther
afield, by many accounts, focusing
on cities that they could fly to di­
rectly such as San Francisco, Se­
attle, and Atlanta.
1989
It is difficult to underestimate cur­
rent demand for U.S. real estate by
both for.eign and institutional
investors. Anyone who doubts the
financial strength of the interna­
tional community would do well to
examine this excerpt from a recent
special report on global finance

7. Salomon Brothers, Inc., R~al J::slale R~'ums and Risks: A Survey (New York: Salomon Broth­
ers, Inc., February 1988).
8. Julien J. Studley, Inc., Studley Report & Spac~dala (Chicago, New York. San Francisco. W8~­
ington. D.C.: Julien J. Studley, Inc., NovemberfDecember 1988).

Gelbtuch: The World of Commercial Real Estate 471

eproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 published by The Wall Street Jour­
nal. 9 which revealed the following:
Classification
World's largest public companies'
W~rld's largest banksb
World's largest insurersb
World's largest securities firms c
Total
a: ranked by market value
b: ranked by assets
c: ranked by capital
Real estate prices in the United
States remain a fraction of those
found around the world, making
U.S real estate attractive to foreign
investors with substantial swns who
seek comparatively high returns
with relative safety. Globalization
Perhaps a new of pricing is continuing. Domestic
approach to value investors have found it increas­
is needed-one that ingly difficult to compete for tro­
reflects the present phy properties unless they price
slrong worldwide their offers according to interna­
institutional demand tional, not domestic, return
for high quality requirements.
U.S. real estate. Several foreign investors have
reportedly recently stopped using
OCF analysis on the theory that they
will not sell their properties. (Sell­
ing real estate in Japan is fre­
quently viewed as a sign of fman­
cial Weakness.) A targeted fIrst-year
capitalization rate may have be­
come the most important invest­
ment criteria.
CONCLUSION
It is predicted that pension fund
sponsors will invest over $2 tril­
9. Dow Jones & Company, Inc . • "Global Finance, ~ The Wall StrullounuIl. September 23.1988.
472
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
lion in U.S. real estate by the
1990s. It appears that we will re-
Country of Origin
Japan u.s. Other
9
9
3 6
~ -2 1
25 13 2
main in an era of "too many dol­
lars chasing too few properties" and
that institutional buyers wiJI con­
tinue to buy assets, whether they
be New York City office buildings
at a fraction of Tokyo prices, or
Houston properties at a fraction of
replacement cost. Several pension
fund sponsors have reportedly
bought at nonsensical prices after
having tired of waiting for deals that
made economic sense while under
pressure from their clients to in­
vest. Just as for some property types
valuation techniques have evolved
from direct capitalization and
GRMs to mortgage equity to DCF
analysis, perhaps we are now on
the verge of needing a new ap­
proach to value, one that reflects
the present strong worldwide insti­
tutional demand for high quality
U.S. real estate.
The Appraisal Journal, October 1989