2008 Outlook for the Commercial Real Estate Industry
By Stan Ross
Chairman USC Lusk Center for Real Estate Board of Directors
December 4, 2007
The last severe downturn in U.S. commercial property markets was during the savings and loan crisis of the early 1990s. For longtime real estate professionals, that downturn is but a distant memory; for others, it is something they have only read or heard about. Regardless, every executive in every sector of real estate needs to be prepared for the risk of another downturn in 2008. No one knows what will happen, of course, but executives cannot wait to see if a storm will hit, or how severe it will be.
Contingency planning begins with what I call a health checkup. Executives of development, investment, property management, services and other real estate companies first evaluate the health of their organizations. Then they look at the effects on their companies of external forces such as U.S. employment growth, consumer spending, or interest rates as well as local market forces such as employment or retail sales. They conduct ongoing market assessments and continually evaluate the impact of market changes. Finally, they consider how to keep their companies stable in 2008 based on different risk assumptions such as a recession, a spike in oil prices, or a continuing credit squeeze.
Key areas to consider in a health checkup include:
INTERNAL
Development pipeline
- Land inventory: land owned or under option
- Proposed developments
- Development deals under negotiation
- Deals closed but not yet under development
- Development projects in the pipeline
In looking at its land position, a company considers such alternatives as continuing to own the land, selling selected land parcels, continuing to hold options, or, depending on the penalties and other issues, canceling options and releasing the land. It also decides whether to move forward with proposed developments and deals currently under negotiation, or, depending on the penalties and other issues, whether to discontinue negotiations. Finally, if deals have been closed, of if projects are in the pipeline, it decides whether to start, continue with, postpone, or cancel projects. If a project is in the very early stages, the company may absorb the costs of a postponement or cancellation; if it is further along, the company may finish the project and try to recover its investment from the lease-up or sale of the building.
Properties
- Inventory of existing buildings: location, type, square footage, etc.
- Occupancy rates: by geographic market, individual properties
- Leasing activity: current leases and status including any delinquencies and amounts; lease renewals currently under negotiation; leases coming up for renewal in 2008, etc.
A detailed review and analysis of its asset portfolio provides a company with current, accurate information about its properties and how they are performing based on occupancy rates, leasing activity, tenant quality (for example, a tenant's credit rating), status of lease payments, lease delinquencies, etc. Such an analysis provides an early warning system of potential problems such as a slowdown in lease renewals or increases in lease delinquencies.
Income
- Rental income
- Other income streams (parking, leasing of commercial space, tenant services, etc.)
- Property sales
A company reviews its current income from rents and other sources to ensure that it has an up-to-date, accurate picture of its cash flow and determines whether it is meeting its cash flow goals. It prepares a forecast of its income in 2008, including whether its income might be less than expected if there is a property market downturn. It also does an analysis to determine how competition from other properties will affect its rental rates and other income. Landlords could face a more competitive market environment in 2008 if the economy slows and some tenants choose not to renew existing leases or sign new lease contracts or decide to lease less space than they planned. Some landlords may not be able to raise rents as much as expected, and some could face greater risks of tenants falling behind on rent payments. Landlords need to evaluate the financial condition of their tenants and take the initiative in meeting with tenants to discuss their ability to make rent payments going forward and their plans to renew leases. They also can meet with prospective tenants to determine if there are any changes in their plans to rent space.
Costs
- Land acquisition costs
- Development costs
- Operating expenses
As with its income analysis, a company prepares a detailed, up-to-date analysis of its costs from land acquisition and development to managing and operating its properties. It compares its costs with its development and operating budgets to identify cost overruns and look for opportunities to identify cost savings. A company may hold off on acquiring land for future projects to see if land values might level off or decline in some markets in 2008. It may be able to identify ways to better control energy costs, for example, by entering into contracts for future purchases of fuel at fixed prices, reducing electricity use during peak periods, or entering into maintenance service contracts that cover all of a company's properties at lower rates than for one-off contracts on individual properties.
Capital
- Cash on hand
- Access to capital (from lenders, outside investors)
Companies look at their available cash, how much capital they can access, their financing costs, and their sources of capital to determine whether they will have sufficient capital to finance their business operations and property investments in 2008 and to take advantage of any opportunities to buy assets at lower prices. With credit markets tightening, and credit costs increasing, companies might also look at accessing lower cost equity through joint ventures on projects, or by selling interests in their companies to equity investors.
Debt
- Debt outstanding
- Debt covenants
- Debt service
- Financing costs
A thorough analysis of its debt structure, obligations and covenants may enable a company to anticipate problems that could result from a downturn in commercial property markets in 2008. For example, if the cash flow from a company-owned property declined, the mortgage could be impaired and the loan could be in technical default under terms of the company's loan agreement with its bank. Such defaults could also be triggered by a variety of other issues such as a company's not meeting required debt/equity ratios on its loan portfolio or not having sufficient net worth. At the first signs of a problem, a company should take the initiative to meet with its lenders. Together they may be able to work out relatively simple solutions, such as the lender's granting the company a technical waiver on a default or making minor modifications to a loan. But the company must also be prepared to propose solutions.
Might it be able to increase rents when leases roll over? Or lease currently vacant space? Or provide new or additional tenant services that could generate more cash? I recently participated in a meeting in which bank officials were pleased that a company had an early warning system and had brought their attention to a problem early on; and they were happy to work with the company in resolving the issue. Conversely, if a company is slow to alert its lenders, it might have to ask them for stronger remedies, such as reducing, deferring or accruing some of the interest on a mortgage, or a moratorium on interest or principal payments, and this can result in more protracted negotiations and more difficulty in finding a solution.
EXTERNAL
As part of its health checkup, a company also examines the external forces that drive demand for real estate generally and for the company's properties in particular. These include:
Economic indicators
A company analyzes economic indicators both nationally and in local markets where it has properties. Among them are current and forecasted employment growth, unemployment rates, consumer spending, and interest rates.
Demographic trends
Population growth, workforce growth, immigration and other demographic trends can provide a company with information on how well markets where it has properties might be able to weather cyclical downturns. Markets where long-term growth is strong might be able to bounce back more quickly from cyclical downturns than those with systemically weak growth.
Business indicators
The revenues, profits, share price, capital spending and other measures of the health of companies generally, and particularly of companies that are clients of property firms, provides another indication of the outlook for next year. Are clients becoming more cautious in their plans for capital spending or hiring in 2009? How will their plans affect demand for real estate? Companies should also monitor regulatory and legislative proposals to evaluate the possible implications.
Government spending
Many states and localities are facing lower tax revenues because of the housing slowdown, and they are considering whether to cut spending on infrastructure, education, healthcare and other public services. Any cutbacks could influence decisions of companies about where to locate, build facilities, or hire workers, and this, in turn, could affect demand for real estate. Governments might also lean on the real estate industry for more tax revenue, for example, by increasing fees associated with development projects.
"What If"?
As a final part of their health checkup, companies need to develop contingency plans based on different scenarios of what might happen both to the U.S. economy and commercial property markets in 2009 and to the local economies and markets where they have properties. Companies may decide against exercising options to acquire land, or decide to sell selected assets in their portfolios, or put in new cost controls, or restructure their debt or take other steps to hedge against such risks as a recession or property market downturn. But these decisions cannot be made in a vacuum. Companies need to have transparent, frequent and candid communications with their investors, lenders and creditors, clients, employees and business partners.
By having a clear understanding of their organizations -- projects, cash flows, costs, liquidity and financing -- and the national and local market economic, business, and property market environment, developers, investors and other real estate organizations will be better prepared for whatever happens in 2008.
They cannot control events, but they can be ready.