Prospering in a Turbulent Economic Climate

[ By Ellen Rand ]

Adjacent to MIT in Cambridge, Mass., 35 and 40 Landsdowne Street in University Park features a total of 417,061 square feet of office and hotel space, state-of-the-art research laboratories, an auditorium and other amenities.

Baron Nathan Rothschild's famous piece of investment advice was to buy when blood is in the streets. Commercial real estate isn't quite there; there's no wholesale distress, nor is there a giant overhang of vacant, speculative space. Yet by most accounts, we are in the midst of a transitional period (or a pause or a trough or a downturn or even a sea change, as some observers have suggested), which means that the "cycle-tested" developers and owners who avoided being caught up in the exuberance that came to a screeching halt in mid-2007 are well-positioned to find new opportunities in the next year or two and beyond.

Of course, the rules of engagement have changed; debt financing may be available but at higher cost and stiffer loan-to-value ratios. Investors and lenders alike are pricing risk: looking at such basics as current rent roll and not making assumptions about higher future rent revenues. While bargain-basement pricing is not to be found, well-capitalized developers and owners are finding acquisition opportunities, as well as broadening their services, focusing on building healthcare facilities, joint venturing with educational or financial institutions and investing in debt.

Christopher Lee, president and CEO of CEL and Associates, observed, "Real estate is a marathon, not a sprint. You can get a lot of angst over the short-term." For Lee, there are plenty of reasons for optimism. He believes that between now and 2010, we will be in a period of turmoil - defined as a time of uncertainty, disruption, with events occurring in a sudden and unexpected way -- a time to capitalize on distress. This should be followed by a transitional period of growth, from 2010 to 2015, characterized as more structured and organized -- a time to capitalize on knowledge. The era of opportunity and challenge will end with a period of transformation which will be the time to capitalize on relationships.

Lee sees healthcare as a key opportunity for developers and investors. "Between 2007 and 2015, three out of every 10 new jobs will be in the healthcare sector," he said. Pharmaceuticals are growing as well. As corporations consolidate and look for efficiencies and controlling occupancy costs, there will be build-to-suit opportunities too. Cities and municipalities concerned about their tax base will be more encouraging to mixed-use and redevelopment, representing another opportunity. Generally, Lee said, "the number of deals we're seeing is tremendous." There are more opportunities in value-add and development properties, versus core properties. Some opportunities arise out of the misfortune of others, while others are due to decision-makers' preference for working with companies with strong track records that they have worked with in the past.

Lee's advice on how to navigate the current climate? "Don't think that yesterday's press clippings and relationships are going to continue into the future," he said. "Take nothing for granted. The debt market is constricted, so don't assume you've got financing secured. Don't get crazy about how you compensate people. Results are important. Make sure you understand your customers. Don't become complacent." And while thinking "green" may go without saying, Lee doesn't expect sustainable development to take place on a wide scale until 2013. Moreover, he advised against ruling out the notion of joint ventures, public/private partnerships and collaborations between companies that would ordinarily be competitors.

One notable recent example of an owner/institutional partnership is the new joint venture between the California State Teachers' Retirement System (CalSTRS) and Dallas-based real estate investment firm Sealy & Company to acquire and develop a portfolio of industrial properties across the country. The venture will be managed by Des Moines-based Principal Real Estate Investors (PREI) and launched with a combined commitment of about $200 million. The partnership is targeting markets in the Southeastern, South-central and Southwestern regions of the United States.

A Shift in Thinking

A $10 billion public company, FCE is diverse as a major player in office, retail and residential properties. It will continue to be active in all those sectors, but according to Wuest, may shift from new development to potential acquisitions. The focus has gone more toward major markets: New York City; Washington, DC; Boston; northern and southern California; Chicago; and Denver. It is also moving into the Southeast and making inroads in Dallas. "We will stick with our core, where we have a market presence," Wuest said. Other opportunities might include investing in debt and helping others recapitalize their portfolios.

Wuest also commented, "This a great time for a company like ours that can add value at the operating level, with financial strength. It's a great time to have dry powder, but you have to be careful how to use it. I don't think people will be looking to stretch on deals, whether it's on price or quality."

Pat Ryan, president of Ryan Companies, whose top-line revenues he expects will probably be off 10 percent this year, also sees the current climate as a period of adjustment. The company is doing more in the healthcare field, which has become more mainstream in the last five to 10 years, he said. Key issues: the distance of a development from the main healthcare providers; how to shore up the credit of tenants (doctors are LLPs, so doctors' guarantees are required). "Underwriting that credit is critical," he said.

Rather than pursue new geographic areas for office development, Ryan will "go deeper and broader in areas we're in," he said. The alternative energy marketplace also represents an opportunity, from a construction as well as a development standpoint, including ethanol and wind generation or gasification. "We don't know how it will mature; I don't know that anyone does, but we expect it will be a significant contributor," commented Ryan. He also noted that, "We're well-capitalized, which works to our benefit." The company is picking up a 120,000-square-foot healthcare project that another developer was to have built, in part because there are city incentives that have a deadline, and Ryan will be able to meet it. The company also expects to pick up some other developers' retail deals that fall through.

"We don't know what will happen to land pricing on the commercial front," said Ryan. "We're looking at that cautiously. When in doubt, we will sit on the sidelines."

Focus on Healthcare, Educational Facilities and Services

Carter is also emphasizing the "full" in full service: property and facility management, asset management and project leasing for third parties not staffed to do that or outsourced brokerage; various services to corporate America, such as lease administration, multi-market lease transactions and asset or space acquisition. Carter is also involved in joint ventures where another developer has defaulted.

Carter's strategy is to "try to be pre-emptive," Terrell said, which means seeking off-market assets. "We don't want to be in a beauty contest with 10 other buyers. We shy away from that kind of bidding war." The company is looking to acquire a suburban office building whose investor is in arrears on debt service - that opportunity came about as a result of a conversation with the lender's attorney, for example.

"I'm not sure the other shoe has dropped yet on this downturn," he noted. "I'm optimistic that we've seen the bottom, but I don't know how long the bottom is. There's six million square feet under construction in metro Atlanta -- that's a little scary." Absorption in the first quarter of 2008 was significantly below that in first quarter 2007. Like many other industry observers, Terrell believes that the current climate calls for a return to the basics. "I'm 'cycle-tested' but this is the first time we have so many factors we didn't have to deal with before -- China, the devaluation of the dollar - it impacts how we operate and how we recover," remarked Terrell. "Unfortunately this is an opportunity for the industry to purge itself of some excesses."

Both Ryan and Carter are currently focused inward as well as looking at arising opportunities: seeking to trim operating costs, taking a harder look at company policies, practices and inefficiencies. In Ryan's case, a nearly three-year-old commitment to a new computer system should result in a 30 percent savings in office overhead, with a portion of those savings expected this year. "We want to become better stewards of our resources, generate savings and be more efficient. That will bode well for the long term," noted Terrell.

Back to Basics

If vacancies are starting to rise, existing inventory will suffer as new buildings come on line in some markets. He advised owners to look for urban infill or suburban niches as opportunities for new development and renegotiating longer-term leases with existing tenants at current rates. Owners should also "align themselves with markets that have access to global ports, import/export traffic or inland ports. Stay clear of older properties that can't be redeveloped to hold big warehousing possibilities." Novosel also advised owners of existing buildings to "provide as much green" as possible, to take advantage of tax deductions available.

Joseph Pasquarella, managing director in Integra Realty Resources' Philadelphia office, expects that commercial real estate property values will stay flat or grow, as opposed to suffering a massive decline in pricing.

The company does valuation and consulting with its volume in 2007 up from 10 to 20 percent over 2006. The firm is engaging in more workouts for single-family subdivisions and ongoing development, expecting to do 100 to 150 such projects this year. But none involve commercial property workouts. "I don't have any jitters," he said. "Pricing is still good; however, there is a slight disconnect between buyers and sellers. Buyers want to use press stories as ammunition, but there is no prima facie evidence that prices have declined. Developers and lenders in our area have been pretty prudent about money for speculative development."

Opportunities in Debt Financing

Analyzing a property for potential acquisition or for investing in a mezzanine loan involves the same valuation exercise, noting, "We will play anywhere in the capital structure that makes sense for us."

Contrary to what some might think, Shorenstein said that "there is no market discount for debt." What concerns him is that some debt pieces are underwater, that is, the debt is higher than the value of the property. "If values drop 10 to 20 percent and loans are at 90 percent [of pre-2007 value], how do you pay the debt service? No discount would be enough." For a debt investment to make sense, Shorenstein said, the borrower should have real equity in the deal and a low risk of default. "Where you don't understand underlying collateral, you get hurt," he said. "I don't believe in loan-to-own, because you own when you don't want it," he remarked.

Shorenstein has a 30 million-square-foot portfolio that is 54 percent levered and 95 percent leased. It is active in all major markets in the U.S., gravitating to Class A properties. Shorenstein believes that the office sector "clearly has to be turning down. Securitized debt has been totally frozen since August. We're heading into a recession, if not there already, and rents don't rise in a recession." Presently, he likes Houston, where the company purchased two office buildings, largely because its market is not correlated to the financial sector, there hasn't been a lot of new construction and "it is much more diverse this time around."

Shorenstein believes that, "We are back to a world of understanding real estate fundamentals and how to execute; how to get access to debt, lease your properties and not over-levering. We are coming out of a momentum-driven market. It was almost like real estate day-trading. That game is finished -- heading into a down cycle you have to know how to execute." He predicted that there will be a washout involving loans that have not yet come due: bridge equity deals done in the last year that are in default or about to be. "Unless the market turns around, default rates have to rise," commented Shorenstein.

Allen Smith, CEO of Prudential Real Estate Investors, noted that "the credit crunch and weak economy have disrupted deal flow everywhere. With all the uncertainty in the capital markets and economy, we really have no favorite property types today. Unlike the past few years, when almost every deal had a fairly good chance of meeting or exceeding investors' expectations, the risks and opportunities are very deal-specific today. In many ways, our focus on building solid relationships, relying on experience and sound underwriting, has come back into fashion, providing opportunities for our investors that simply didn't exist when capital was cheap and abundant." Prudential is seeing "attractive opportunities in the capital markets, particularly in the mezzanine segment of the market where risk has been re-priced." He remarked that it is unclear if the re-pricing has been overdone, but the absolute and risk-adjusted returns for mezzanine investments are more attractive than equity returns.

"Sentiment and expectations clearly have changed since a year ago," he said. "Perhaps the biggest shift over the last year has been the radical change in the psychology of the market. Investors, lenders and tenants have no sense of urgency and that has shifted the balance of power 180 degrees -- from borrowers to lenders, from sellers to buyers and from landlords to tenants. That change, along with the increasing cost of capital as the industry goes through the same deleveraging that's working its way through the rest of the economy, is putting upward pressure on yields and cap rates, and downward pressure on rents. "Hopefully, when the credit market crisis eases and the near-term outlook becomes a little clearer, foreign and domestic investors will have enough confidence to begin deploying some of the capital now sitting on the sidelines," he said.