The real estate industry has long been divided between large and small companies. But speakers at the USC Lusk Center’s Annual Retreat for industry leaders said a new fault line is emerging in Enron’s aftermath: balance sheet strength. Regardless of size, companies with the strongest balance sheets and credit ratings will have an edge not only in their ability to obtain capital but also to secure it at a lower cost. To be sure, banks and other lenders have always evaluated a company’s balance sheet in deciding whether to provide debt financing. In the post-Enron climate, however, creditors are paying much closer attention to company balance sheets, including those of real estate companies. And they are tightening their standards for providing debt financing to real estate companies -- for example, by requiring companies to put more of their own equity into development projects or property acquisitions. For every $100 that goes into a development project today, $60 to $70 is borrowed money, and $30 to $40 is the developer’s equity. Under the credit standards of a decade ago, a developer could have borrowed up to $100. What this means, said Sam Zell, chairman of Equity Office Properties Trust, is that $3 million in equity doesn’t buy what it used to. A developer who invested $3 million in a project a decade ago would have to invest around $10 million in equity in the same project today. “The equity requirements are enormous,” Zell commented. He was a keynote speaker at the recent two-day retreat, held in Santa Barbara, California, and attended by nearly 200 industry leaders. Even before Enron, real estate company balance sheets were coming under closer scrutiny. As small, private organizations, real estate companies were mainly competing with similar companies in trying to obtain financing, usually from local banks or other lenders. Now, some of these organizations are large public companies, and they are competing for capital in the public equity markets. Their success in raising capital depends to an increasing degree on the strength of their balance sheets. A trend towards balance sheet based financing, and away from traditional project-based financing, could mean that developers will have more difficulty in borrowing money collateralized by individual projects. Some speakers at the retreat said more developers may form more joint ventures with REITs, opportunity funds, pension funds and other institutional investors who have access to lower cost capital. But lenders and investors will scrutinize such ventures and expect them to have greater transparency in Enron’s aftermath. With balance sheets in the spotlight, companies are looking for ways to improve their balance sheet performance. Barry Sternlicht, Chairman and CEO of Starwood Hotels & Resorts Worldwide, Inc., said Starwoods has adapted the Six Sigma process, pioneered by GE, to its operations. (GE describes Six Sigma as “a highly disciplined process that helps us focus on developing and delivering near-perfect products and services.”) Among other programs, Starwood has implemented a series of human resources initiatives such as performance bonuses and peer reviews to increase productivity, reduce costs and increase customer satisfaction. Because more investment capital is expected to flow into real estate in 2002, both in investment in REITs and in direct property investments, real estate companies have a strong incentive to strengthen their balance sheets. Bowen “Buzz” McCoy, President, Office of Buzz McCoy, and moderator of a capital markets panel, noted that in contrast with a decade ago, real estate markets are not overbuilt, and higher vacancy rates are a result of a slowing in demand more than an excess of new space coming on the market. As the economy continues to recover, demand should increase, and as more space is absorbed, vacancy rates should decline. With real estate markets expected to improve, and corporate earnings falling short of investor expectations, several speakers said that pension funds and other institutional investors are likely to put more capital into real estate this year. Suburban office properties and hotels could be of particular interest to investors. In 2002, Southern California, like the U.S., should have moderate growth, although the region’s economy is expected to grow faster than the national economy, said Raphael Bostic, Director of the Lusk Center’s Casden Real Estate Economics Forecast. In contrast with Southern California’s manufacturing-dependent economy of a decade ago, the region’s economy today is more diversified, and less vulnerable to downturns in manufacturing. One thing that real estate companies do have in common is higher costs for terrorism insurance -- assuming it is available -- as well as for other property insurance. Since 9/11, such costs have increased 200% to 400% or more for many companies as insurers try to pass through the costs from payouts related to 9/11 and other claims. Even smaller projects and properties have been hit with higher insurance costs. No company has escaped higher insurance costs, but larger companies may have a cost advantage. Richard Gentilucci, Senior Vice President, Development – Real Estate, Shamrock Holdings, and a speaker at the retreat, noted that larger portfolio owners can spread such costs over more assets. Barbara Cambon, Principal and Chief Operating Officer of Colony Capital LLC, said that the need for terrorism insurance and higher costs will drive “mass and scaleability” in the real estate business. Congress has considered but so far has not enacted legislation to mitigate the high costs and reduced availability of terrorism insurance. Check the USC Lusk Center Web site in coming weeks for in-depth articles on the Lusk 100 annual retreat including presentations by Jerry Brown, mayor of Oakland and former governor of California as well as discussions on entitlement and development; the outlook for California’s economy and real estate markets; and the capital markets outlook.
May 29, 2002