Foundation Governors Forecast The Shape of Tomorrow’s Industry

[ By Ellen Rand ]

Leaner. Stronger. Smaller. Lower-leveraged. When recovery comes, that is what the commercial real estate industry will look like, the Research Foundation Governors agreed.

Until then, the industry is still in for a lot of pain – consolidations, layoffs, troubled asset sales, declining asset values and rents. The good news? Those who kept their heads and their powder dry (or sold properties or portfolios in 2006 and 2007), will be well-positioned to capitalize on the difficulties sure to become more apparent over the next year or two.

The Governors recognized some of the same elements of the current recession that afflicted the industry particularly in the early ‘90s, but noted that this time the cycle looks a lot different in troubling ways. Namely:

• The recession is global, not restricted to the U.S.
• The industry’s problems are not self-inflicted, through overbuilding. Rather, they reflect the economic climate and the downturn in global trade.
• The recession has hit white-collar employment – the life’s blood for office space demand – particularly hard.
• The rapid and ubiquitous dissemination of financial information has profoundly affected consumer and investor confidence.

Even if there is a slowdown in GDP and employment declines, the Governors agreed that there is still more pain to come for commercial real estate, as a lagging indicator. “The government says that unemployment is not expected to peak until sometime next year. I would think that companies will resist adding space until after that time as many will have surplus space from downsizing. The implications of consolidations in the financial services sector have not yet been fully realized. This will punish certain markets similar to how the auto industry woes have impacted the upper Midwest,” commented Stephen A. Crosby, NAIOP Research Foundation Chairman.

“Assuming that the space needs of corporate America were being met at the peak of the boom (and double digit vacancy rates would seem to confirm this) it would follow that absent massive structural or locational obsolescence, the country’s commercial space needs could well be met by existing stock until the economy reaches prior levels of employment, production and consumption. In general, I see the overall economy rebounding more quickly than commercial real estate. I also think that the corporate focus on general and administrative expenses will be intense and long lasting,” he noted.

“We haven’t seen the bottom of this trough yet,” said Dwight Taylor, noting that there will be significant downward pressure on rental rates thanks to a combination of loans coming due and leases expiring or renewing. Similarly, Ron Rayevich said that “it will be 2010 or 2011 before we come out the other side,” expecting the recession to end no sooner than the fourth quarter of 2009. George Livingston’s trepidation is that the recovery, when it comes, will be slow and that the GDP will not return to previous high levels until 2015. Douglas Howe’s concern is that the recovery may be jobless and that “it will be five years before we get to where we were in 2007” in employment levels.

Rick Woodruff pointed out that “there won’t be any demand for new development for three to five years.” He also remarked that WWR Real Estate Services has 500 tenants and that every day there is a phone call from a tenant asking for a rent reduction or some other form of relief.

Not all markets are suffering, however. Susan Graham reported that Hawaii – with office vacancies at eight to 10 percent and industrial and retail vacancies at three percent – is not faring as badly as the mainland. Although the market has not been overbuilt and the residential market is not plagued with subprime difficulties, she reported that she will be working with some owners on restructuring leases where rents are too high.

Readying for Recovery

Governors are adopting a variety of strategies to optimize real estate operations now as well as prepare for a more opportune-laden future. Frank Wuest noted that “we’re planning as if it will get worse before it gets better,” and that Forest City is dealing with its portfolio in the meantime. That means being aggressive in leasing, taking care of customers, working on refinancing and raising equity because “it’s a time to have cash going forward” because there will be opportunities, although “it’s too early on the buy side.” He noted that “most people who’ve bought debt in the last six to 12 months have lost money on it.” The company has also been approached by lenders, asking for its help in addressing real estate difficulties. “Normally we wouldn’t do that, but it’s good for relationships,” he said.

Consulting, in fact, has become a more attractive line of business for several companies represented at the roundtable. Larry Pobuda, for example, reported that the Stewart Lawrence Group has been hired by the University of Minnesota as a consultant for a new campus. The University’s partners in this enterprise are the Mayo Clinic and IBM. This assignment could involve the company for quite some time and “will position us well as the economy does recover.” Regarding the suburban Minneapolis office market, he reported vacancies edging up to 20 percent and expects that “it will be another six to 12 months before the new reality hits on the rental rate front.”

Bob Cutlip, formerly of First Industrial, believes that the industry is undergoing a paradigm shift. He announced two new ventures in the next 12 to 18 months -- partnering with former NAIOP chairman Al Beaudette, Susan Graham and others to assist developers, institutions and banks with commercial real estate issues — and separately embarking on an investment initiative in the Southeast.

Paul Ciminelli, whose company is active in Western New York and Florida, has an in-house “green team” and has seven or eight proposals out to “green” municipal buildings. “It’s not high margin, but brings money in the door, and we’re doing something good for the economy and the environment,” he said. He remarked that “It’s crazy times out there! We have 600 tenants; there is not one industry or profession that’s been unscathed in this downturn. How can you tell the quality of the rent roll anymore? What’s a blue chip tenant anymore?”

The company has gone through a process of becoming leaner, taking a hard look at staff to determine who it needs and who it wants. As a result, he said, it is “honed down to a good nucleus.” As for the future, the company may be rebuilt in a different way, becoming more of a virtual model where various functions can be outsourced, an approach endorsed by Douglas Howe: “If it’s not critical to our mission, we outsource it,” Howe said of Touchstone Corp., adding that “we have become lean. We can ramp up in good times by assembling and mobilizing our strategic partners.”

Ron Rayevich observed that consultants face a new kind of challenge than they had in prior downturns because “the loans have been sliced and diced in so many ways.”

As for purchasing debt, Rick Woodruff reported that his company has already had one opportunity to buy a distressed loan at a 50 to 60 percent discount and that this is a hint of what’s to come. He acknowledged that owners of buildings that are not highly leveraged, with a Triple A tenant roster and 98 percent occupancy, may be in for a shock if a property’s loan is coming due; the new economic reality may require an additional $5 to $7 million in equity just to get that loan refinanced. As Alan Kahn remarked, “This is not a happy time to be dealing with lenders. The re-appraisal process is making it extremely difficult for refinancing — the dislocations are hard to deal with.”

Jonathan Tratt reported that his company is focused on stabilizing its portfolio in Phoenix and looking to raise capital, noting ruefully that “I thought industrial was the stable part of the market basket. I’m optimistic about the Phoenix market over the long term; the market has seeds of growth,” he remarked.

Alan Kahn said that his Columbia, South Carolina, company is like many others who are focusing on maximizing control over its existing assets rather than using leverage to increase the size of the company’s portfolio. If private financing is a challenge, so is being a public company. Dwight Taylor, recently retired from Corporate Office Properties Trust, pointed out that “if you’re a public company, [Wall Street] is looking over your shoulder all the time. It affects your ability to raise funds.” Taylor also believes that with so many talented people out of a job in the industry, it represents a hiring opportunity and a chance to “look at your organization and say ‘let’s retool some of this,’ and improve your cost structure.”

S.A. Klatskin was among those in the “finding opportunities now” mode: he reported that NJ-based Forsgate Industrial Partners is looking at land for development purposes. “We’re seeing major consolidations in the industry as well as some motivated sellers who weren’t at the table before,” he said. “Some terrific sites are coming to the market now that otherwise would have been too expensive. It’s also a terrific environment to buy construction.” Klatskin said he expects to be in the ground by year end with an industrial project that can lead the market as a state-of-the-art facility, on a low-cost basis, delivered by the end of 2010 or early 2011. He underscored the importance of being able to analyze a building, “not paying attention to the rent role, the cap rate, what the exit cap is going to be” – concentrating instead on whether or not it can support demand if it is empty.

The Post-Recession Landscape

The Governors agreed that the commercial real estate business, post-recovery, will look different in expected – and perhaps unexpected — ways. As Paul Ciminelli noted, “The days of financial engineering are gone for a while.” His company’s investment goal, like many of the Governors, will be to make money on buying property right and operating it well. “The sell is the bonus part,” he remarked. He also expects that GDP growth will be 2 ½ percent and “we don’t know what the regulatory climate will look like.”

Also gone will be high leverage. Higher equity requirements and lower loan-to-value ratios for mortgage financing will almost certainly lead to more joint ventures between capital partners and skilled developers with knowledge of local markets, commented the Governors. Moreover, some owners will opt for holding assets over a longer term to create value, getting returns over several leasing cycles. But they also believe that financing will return in some fashion. “It will not be at the level it was, but the money will come back, in a new way,” Rick Woodruff said. Alan Kahn predicted that as much as the Federal government has made a market in residential mortgages, so too will it find a way to securitize commercial real estate loans. “It may take two or three tries, but they’ll get it right,” he said. “It can work if it stays limited.”

The Governors also expect to see growth of small commercial real estate businesses, principals and service providers alike. As Bob Cutlip pointed out, “It’s about strategic partnering.” At the same time, he is concerned about the loss of young people in the industry because of consolidation. “We have to think about how we grow the next generation of stars,” he said.

In the “unknown” category are the impact of the Obama administration’s stimulus package, TARP and TALF on the industry. George Livingston reported that his company has been approached by a stimulus-motivated fire department in Florida about buying two buildings to accommodate its equipment. As a result, his company is looking into getting on government bid lists with the aim of doing real estate work for government agencies.

Lesser known will be the impact of green mandates by regulatory agencies at various levels of government. But the Governors see many reasons to be optimistic on several fronts.

Bob Cutlip cited such fundamentals as population growth, a deep pool of talent and a growing middle-income group around the globe as good signs. Douglas Howe sees biotech and biomed as growing sectors and stressed the importance of continuing to plan for build-to-suits in Seattle because there is still a two-to three-year entitlement cycle. Others agreed that educational institutions, as well as healthcare, would represent opportunities sooner than other industries. As for which property categories will recover first, Ron Rayevich predicted that hotels will revive faster than other categories, followed later on by office, industrial and retail.

Douglas Howe predicted that post-recession, “there will be 25 percent fewer developers, but that the companies emerging stronger in their local markets will be those who are preparing for the upturn by doing pre-development, hiring strategically and acquiring good properties at significantly lower values than they were built for.”

For more information on recently released NAIOP Research Foundation reports, to go www.naiop.org/foundation/completedresearch.cfm