Since the economy’s near-meltdown three years ago, the industry has been struggling with the recession, unemployment, debt overhang, a disappearing-then-reappearing-then-contracting CMBS market, a toxic political environment and European bank woes. Development caught up with eight former NAIOP Chairs, all of whom had experienced previous downturns, and asked their thoughts and observations on the last three years.
All agreed that this has been the worst in their professional lives: longer, deeper, more unpredictable and more painful. As Larry Pobuda remarked, “Anyone who’s a principal who says things haven’t changed dramatically is being disingenuous.” Douglas Howe concurred: “This is a tough time. You can’t put a happy face on it. We’re working harder than we ever did before.”
Most of the Chairs do not foresee a strong economic recovery for at least a few years. But they also agreed that from a strategic perspective, they could not sit and wait for opportunities to arise before tackling new business. A few have ventured into different kinds of commercial real estate; others are resolute in staying within the realm of their proven expertise.
On the positive side, financing is accessible today, which it was not three years ago, although the terms are considerably tougher. Institutional investors are back, too, as are opportunity funds poised to jump on distressed assets and debt. While earlier this year some institutions and advisors had tiptoed into core-plus assets and secondary markets in search of higher yields, now they are back to focusing on core properties in gateway cities. “Core is no longer boring,” said Mike Mullen.
Steve Crosby readily admitted that he is not the “normal” NAIOP member – CSX Real Property did more development several years ago but now invests in support of its railroad parent. However, some of the company’s experience has been emblematic of the times. For example, when everything froze for six months starting in Fall 2008, a residential joint venture set to close didn’t, missed by two days. (Now CSX is getting into the same project in the Baltimore-Washington, D.C. corridor with different people.)
As a tenant looking for space, however, “it was a wonderful time,” he said, pointing out that while the company’s employment has remained steady, it needed less space thanks to technology-driven productivity, new office systems and reconfigured office layouts.
“There has been more interest among customers now than three years ago in finding suitable manufacturing facilities near the railroad. Some of this interest is starting to mature, but it’s more due diligence than turning of dirt,” noted Crosby. Generally, he sees “no clear line of sight in terms of where things are going. There isn’t certain demand for product. Demand uncertainty is a bigger factor than other factors,” he said, including the political/ regulatory climate and market volatility.
The nagging question now is: Where is the demand to drive sustainable lease rates? In most markets, fundamentals like vacancies, absorption and lease rates are poor. Moreover, for many loans coming due on commercial real estate, the fundamentals are too wan to support refinancing at original levels.
Crosby pointed out that in previous recessions, something would present itself as a driver of demand, such as the explosion of technology, telecom and burgeoning dot-com companies. Now the picture is unclear. “There will be another ‘something,’ but I don’t know what it is,” he commented. Douglas Howe, whose company’s growth hinges on technology and knowledge-based businesses, remarked, “Maybe it will be a recovery of haves and have-nots.”
Sticking to Their Knitting
“We continue to look for a blend of fee income from development and putting our own equity in deals. We’re making decisions predicated on recovery within three to five years.” – Larry Pobuda
More conservative underwriting by lenders plays into the business strategies of several Chairs. Alex Klatskin said, “We do things exactly the same as before. We are extremely conservative and will continue to be, always with low leverage. Our investment philosophy is ‘home for dinner’ and we are lucky enough to be in a large enough market to do that.” An industrial owner, Forsgate is active in northern and central New Jersey. If Klatskin has any regrets, it is that the company pulled back on certain acquisitions when it might have made sense to go forward.
Like Forsgate, Elberon Development concentrates on industrial properties in New Jersey. Anne Evans Estabrook remarked, “We have a niche. We are a family company. We don’t try to be something that we’re not.” Some of the bigger REITs active in this market got badly hurt in the last three years, she pointed out. “In ’08 we signed leases with AMB as a joint venture partner [for an industrial property] for $9 per square foot for new space,” she said. “There’s 24,000 square feet left. We’d take $5.50 now if we could find someone to lease it.”
Joan Woodard, whose property, asset management and architectural firm focuses on Sonoma County, Calif., noted, “We look at ourselves as community builders. That’s why we’re only in Sonoma County. It works for us to be that connected to the community; it’s a unique niche.” Sonoma County is where the firm has an innate feel for its indigenous materials, its lighting and the way buildings relate to their environment. The firm is doing public/private partnerships for community buildings to keep its architectural business going.
Anticipating a downturn of some significance in 2007, Woodard said, “We insisted that our owners hold on to cash flow for reserves. In some cases, they weren’t enough. We had no idea how long it would go or how deep.” Woodard has worked on two refinancings and is in the middle of her first major workout, for which she doesn’t expect a resolution for another nine to 10 months.
She sees fewer and fewer local owner-driven real estate companies, or, as she put it, “fewer people close enough to the dirt. It’s become a financial instrument.” She believes that this divide is bigger than ever and represents a lasting change.
On the positive side, over the past several years Woodard said, “I’ve learned how resilient my staff can be.” The firm downsized in 2007, 2008 and a little in 2010. The staff has taken on extra work, not received raises in three years and contributed to benefits. Yet, she noted, “There has not been a single peep of dissatisfaction or concern — that’s been a pleasant surprise.”
With a Little Help from Their Friends
“Opportunities don’t just arise, they’re created. The good news is that employers are lean and mean today. Once there’s a clear positive signal that the recovery is here, there will be activity at a furious pace. Being prepared is a key to that.” – Douglas Howe
Several NAOP Chairs used the word “fortunate” in describing their last several years. Among them was Mike Mullen. Why? CenterPoint was sold to CalPERS in 2006 and so from 2008 to the present, he said, “We have been blessed to have the largest U.S. pension fund own us. We had access to capital when it was hard to find.” The company has been able to broaden its scope geographically and is developing major intermodal projects.
One of the good things CenterPoint did before the recession, Mullen remarked, was to sell a 25 million-square-foot portfolio, going from 55 million square feet to 30 million square feet.
“We’ve always believed in being lowly leveraged,” he said. “There have been no layoffs here; we run a lean machine anyway. As markets began to turn, we bought cautiously. Maybe we mis-timed the bottom and should have bought more aggressively, earlier in the cycle.”
The Stewart Lawrence Group uses its own capital, but it has also partnered with a national hedge fund which has worked out well. The company has also stayed close to the banks with whom it has had good relationships in good times and bad. In working with funds, Pobuda advised, “Without question you have to make sure that your interests are aligned. That’s critical in any kind of partnership.”
Pobuda said that “we continue to look for a blend of fee income from development and putting our own equity in deals. We are making decisions predicated on recovery within three to five years.”
Pobuda said that probably the best thing the company has done in the past few years is to maintain the core principles that define its business and how it approaches real estate. That means a commitment to quality. He has no regrets about deals the company may have passed on.
Creating New Opportunities
“We’re a small entrepreneurial firm, so we can’t afford to sit and wait for job growth” to fuel demand for space, Pobuda remarked. “We focus on opportunities in medical office, senior housing and student housing – those kinds of developments have demographic tail winds.”
He noted that “new opportunities are different from what we’ve had in the past.” There are opportunities in distressed real estate in the Southeast and Southwest, where the economic pain has been more acute. “We don’t think those markets are going away,” he said. “The returns are greater than in better-performing markets.”
While some in the industry may wish that this recovery could be like recoveries in the past, Pobuda commented, “There’s so much that’s new, widespread and severe. Distressed opportunities are not conventional. We will continue to broaden our horizon in how we define commercial real estate.”
“We have a niche. We are a family company. We don’t try to be something that we’re not.” – Anne Evans Estabrook
Al Beaudette explained that Attentus Advisors’ goal is to support a specific set of clients: high net worth clients and middle market clients. The firm is also involved with Native American and sovereign nation clients. “There are 553 recognized tribes in 48 states and 13 regional and 200 village groups in Alaska. These groups have 100 million acres of land in the U.S., with challenges and opportunities in office, medical center and infrastructure development,” noted Beaudette. “It’s fun and rewarding. At the same time, we’re positioning ourselves for a turnaround, raising money from high net worth investors for a fund that is likely to invest in debt and existing properties. We’re looking at our first deal now,” he said.
Another company preparing for the future is Touchstone. Douglas Howe said, “the best thing we did in the past three years was make the conscious decision to grow our business. We are working on building our development team and have brought in five or six new people. We are also working on succession planning.” The company is doing pre-development work in anticipation of an inevitable recovery.
Touchstone has a strong presence in its market and is retaining its local and regional focus, or what Howe calls “the 45-minute rule,” covering Seattle and the Puget Sound, aiming at tech, biotech, institutional, build-to-suit and business hotels in high growth employment centers. “Opportunities don’t just arise, they’re created,” he said, which is why the company is nurturing relationships with key major employers. “The good news is that employers are lean and mean today,” he went on. “Once there’s a clear positive signal that the recovery is here, there will be activity at a furious pace. Being prepared is a key to that.”
The Future: Like the Downturn, It Will Be Different Too
If a robust economy is really a few years away, and hiding under the covers is not an option, what should commercial real estate professionals do in the meantime? As Anne Evans Estabrook observed, “There are things we can do now to prepare for the future. But we can’t build for the future yet.”
It is more important than ever to carefully analyze prospective tenants’ financial information and do your own proper underwriting, she advised. “Develop good relationships with several lenders and take care of those relationships. They’ll work with you. [Commercial real estate] is still a good business to be in, high or low, if you’re conservative.”
Al Beaudette suggested that real estate practitioners analyze the stresses in this kind of downturn and determine how they can add value to their organizations.
Larry Pobuda agreed, calling the current climate a rich learning opportunity. “Continue to look at what the market is throwing at us. It will be a challenge for the larger companies that have rigidly defined markets and opportunities. Sometimes this industry has a herd mentality, but I’m most comfortable turning left when everyone turns right,” he commented.
Joan Woodard remarked, “These times make it important to have connections with a wide variety of people. There’s a lot of denial in the business. We all have enormous rose-colored glasses. Without a network where people can be honest with each other and forthcoming with information, your decision making will be hampered,” she said.
Alex Klatskin believes that local “buy and hold” owners may have a competitive advantage over institutional investors in finding B properties in secondary and tertiary markets (although Forsgate’s own strategy is to add value to B properties in A locations). The returns can be excellent, he said, but capital must be very patient. Suburban office parks, however, could be problematic – it is possibly an “antiquated model,” he said.
Despite the difficulties, Klatskin believes that “we are in the beginnings of what will be the next boom. A lot of creative things are happening: urban infill, suburban redevelopment opportunities, mixed-use. These are exciting projects that will yield good returns and good public policy.”
“We’ve always believed in being lowly leveraged. There have been no layoffs here; we run a lean machine anyway. As markets began to turn, we bought cautiously.” – Mike Mullen
Steve Crosby sees future opportunities as “smaller, compact and complex,” as opposed to large and generic. Homes, offices and cars are getting smaller and more efficient, although they can certainly offer added value in quality, finishes and operations. “We may spend more money on consumables, but they’ll be less bulky.”
“What’s the real estate analogy of the iPad?” he asked, musing that it would probably be mixed-use development, remarking, “We’re still trying to figure out how to do them successfully.”
Crosby’s advice to real estate professionals in navigating an altered world where generic, commoditized office and industrial space will be less successful? Specialization. He pointed out that the hospitality industry has devised 10 or 12 ways to segment its market, each segment appealing to slightly different types of customers. “We rarely see that in a standard office or industrial product,” he said.