If I Had a Do-Over
How often do we get a chance in life for a do-over?
Who hasn’t looked back at some period of life and wished we had known then what we know now?
What if we had a “way-back” machine to return to a former stage? Would we change our lines, perhaps switch roles to play the canny operator rather than the dupe? Undoubtedly we would use hindsight and change the outcome to our advantage. Would you be interested in that opportunity?
I know I would. And I know exactly what period in time I’d return to. I’d set my way-back machine for 1988-1992.
A Short History Lesson
We gray-hairs in the real estate business who were around back then remember it as the era of the infamous Resolution Trust Corporation, also known as the RTC, the great government boondoggle that destroyed an entire industry—the savings and loans—and decimated real estate by flooding the market with supply. Along with the RTC came a major change in the tax code, and the combined effects devalued commercial real estate by one-third over the next few years.
Why would I want to return to those darkest of days? Because I was on the wrong side of the trend, too much short-term debt secured by long-term assets that were losing value quicker than a new car in a hailstorm. The greatest real estate sale in history was passing before my eyes. Like a dog on a chain watching cars pass in the street, all I could do was bark.
I did get a couple of deals done, but nothing like what could have been if I had the foresight to see it coming. The market was flooded with product, entire portfolios of properties sold for giveaway prices, and government money was flowing like a fire hose to finance the buyers.
Does that sound familiar? Think of a 30-month housing supply, TARP, TALF, a $750 trillion government spending bill, and a tax code built like a theme park.
And before we send our time machine back to the present, note that dozens of today’s biggest real estate companies owe their start to those incredible years of buying entire property portfolios at wholesale prices, including Sam Zell, aka the Gravedancer, who sold his Equity Office REIT for $38 billion in 2007.
As the adage goes, history doesn’t repeat itself, but it often rhymes.
The same conditions that defined that era are forming again. The financial markets are in chaos, real estate markets are glutted with oversupply, and to quote Ronald Reagan, “To say Congress is spending money like drunken sailors is an insult to drunken sailors everywhere”.
The Ultimate Do-Over
I thought I would never see the day when opportunities like those were available again. But it’s happening, right now. And this time I have not only hindsight, but money in the bank and the staying power to take advantage of it. Please God, don’t let me screw this up.
This is the sixth recession of my real estate career. I won’t spend time here analyzing what happened to put us here. There are millions of words written on that subject. What I can tell you is the one thing the previous five recessions had in common was a 100% recovery rate. That’s good reason to believe we will recover this time too, so the most important thing to know is how to catch the upturn.
My sole purpose in this article is to convince you that despite all the media hype and hysteria about the imminent collapse of commercial real estate, the sky is not going to fall, that deals will be made, fortunes created and most importantly, you can participate and profit from the shakeout.
First, let me state that the current hype about massive defaults in commercial real estate is true, but only in a general sense. Understand that the financial media’s definition of “commercial property” includes residential condo and subdivision development projects, casinos in Vegas and marinas in Florida.
It’s a pretty sure bet there are going to be above average numbers of defaults in those types of deals. There will be more headline-making failures of some very big players. The pundits will scream the sky is falling and that all is lost. We should encourage them. The more people that believe that the fewer competitors we’ll have when the time comes to act.
The truth is this is the benefit of a recession, to get inefficient capital and over-capacity out of the system. It’s painful, ugly and unpleasant, but necessary to get to the next phase, which is recovery.
As the market clears the excesses, commercial real estate will return to what used to be normal conditions, when the profits were made by applying the fundamental principles of income-producing real estate in a methodical manner, as opposed to the anomaly of the past few years when the “greater fool theory” was the chief valuation criteria. Redevelopment, change-of-use, infill and repositioning, those will be the winning strategies as opposed to the “turn and burn” practices of the last five years.
Do You Want In?
Consider my favorite truism:
“Opportunity, without the capacity to capture it, is an illusion.”
Many of the distressed properties I am seeing are owned by investors who have never seen a downturn. They have no idea of how to cope. I do, and those like me who understand how to apply the fundamental principles to create wealth with income properties are going to have a field day cleaning up the mess, not to mention being well-compensated for their effort.
I am already finding deals at prices and terms that were unheard of a year ago, and this is just the start. The hardest part is being patient. Whether you’re already in commercial real estate or just thinking about getting in, the waiting period is to your advantage. This is your window to prepare and be ready to act. More on how to do that in a moment.
How to Prepare
Multiple Exit Strategies
In a nutshell, here’s my playbook: Realize that commercial real estate lags the economy by at least six months. We have not bottomed yet. Be ready for early buying opportunities in Q3 & Q4, but the bulk of distress will not hit until early 2010. That’s a good thing, because it gives us time to take the actions that will prepare us to act when the time comes.
Concentrate on raising cash, getting your financial statements and credit report in good order. Start making contacts and build ongoing relationships with community banks. That’s where the money is. If you don’t know how to develop banking relationships, it’s time to learn. It’s a lot like dating. You’ve got to put on your coolest shirt, get over your shyness, and ask the girl to the prom. It helps to have a good plan to share
Position existing properties to weather an extended downturn of demand. This means getting space/units filled, often regardless of the price, e.g. spend the tenant improvement money to break even on the lease. Occupancy-in-place will be more important once the economy approaches and passes the trough (Q3 or Q4 2010).
Because of the lag, ComRE will not bottom until the recovery is well underway, and the major competition for space will be from the sub-lease supply. There will be a race to the bottom in rent concessions and rate, Avoid it.
Now is the Time
Now is the time. Not the time to buy, not yet, but it’s coming. This is the time to get prepared for the opportunities that are on the way. I’m giving you ample notice, way ahead of the curve, and unless you’re ready you’ll miss this train just like I did 20 years ago.
This is definitely not the time to go out and sign contracts on anything offering a price reduction. It’s too soon. For a number of reasons commercial real estate lags the economy by six to twelve months.
I’m buying properties right now, but mostly deals I’ve been working on for a couple of years waiting for the owners to come to reality about value. As I said, the hardest part of this game is the wait. Patience is not my strong suit.
But this is your opening. I’m telling you now that if are willing to spend the next few months getting ready in the right ways, you will have the opportunity to acquire income-producing properties at your price and terms, with guaranteed returns that will dwarf every other investment class.
The most important lesson I have learned is to always be looking around the next corner, and what every recession has in common is a 100% recovery rate. As a stock pundit said recently, there is always a bull market somewhere. In real estate that means finding the markets and sectors that will recover first. Every downturn is different, and it takes some work to figure out where that will be this time.
The strategies from 1988-1992 are not the strategies that will work this time, but the lessons still apply. Figure out where to be, as just as importantly, where not to be. It’s much easier to sail with the wind than against it.
It won’t be the same type of gains we just experienced. I hate to be the one to tell you, but the days of double-digit percentage increases in appreciation fueled by cheap debt are gone, at least for the next 15 to 20 years, because that’s about how long it takes us to forget how bad the hangover is from a binge like the one we’ve been on.
I’ll spare you all of the economic mumbo-jumbo about how we got here, whether the government reaction is right, wrong or closing the barn door after the horse is out. Leave that for the talking heads on TV and the academics. I know what happened and who is to blame, but at this point I’m only interested in one thing.
Yes, there are some large, over-leveraged players now taking a beating, in bankruptcy or writing their petition. There will be more failures, some sizable and alarming, but this is the price of over leverage. The weak players get shoved off the court, the lenders take a beating, and the strong wind up with the best deals in the aftermath. There are already dozens of vulture funds out there sitting on billions of dollars just waiting to pounce.
But for the most part these funds don’t play in my sandbox. I purposely stay in the under $5 million range so as to avoid the deep-pocketed buyers. I also stick to small markets where I know and understand the fundamentals, and can exploit a home court advantage.
How’s that for laying it on the line? In case I turn out to be wrong, I’ll be eating these words for the rest of my life. So be it. I’ve done this before, and had to ignore the naysayers then too
I’m going to give you a peek inside my own company’s strategy to double our assets in the next three years.
This is the sixth recession I’ve experienced in my career, and
The sector that gives me the most concern is the retail sector. From what I see so far the shakeout among retailers is just beginning. And it’s going to get a lot uglier sooner than later. Here’s why:
The analysts I read (and trust) are forecasting a reduction in consumer spending from 70%-71% of GDP down to 60%-62% over the next two to three years, due to two factors:
One, the de-leveraging is happening not just in the financial sector but also in households. As a result the US savings rate is going to return to its historical norms of 6%-8% (from negative territory two years ago).
Two, decreased demand due to higher unemployment and slow wage growth will result in less disposable income, and on a global scale.
Do the math on US GDP of $14 trillion and that’s a potential drop in consumer spending of $1.6 trillion (16% of retail sales) over a relatively short time frame. Talk about stress tests… take any retailer you want to name and back-test their earnings for 10%-15% drop in gross sales and it is apparent that only the strongest will survive.
The effects are already showing up. Retailers are radically reducing their projections for new store openings; a rise in retailer failures and consolidations is underway as we speak; and there is a severe lack of pricing power to increase margins, even for the survivors.
For retail landlords all this points to increased vacancies, increased demands for rent concessions from existing tenants to keep them, and long lead times to re-tenant dark space.
For our company, our strategic plan for 2009 (completed in late Q3 of 2008) was targeted at acquiring distressed retail properties in the latter half of this year. Last fall we believed that the recession would be bottoming about now, and given the lag of ComRE cycles to the economy we felt that the bottom would trail by about six months, hence a target for retail acquisitions in Q3 & Q4, allowing us to ride the recovery.
But after seeing the trends in finance (continuing chaos) and the destruction of demand in auto and housing sales in Q4’08 and Q1’09, we changed our focus. Basically there is no recovery without a recovery in housing, and the numbers I’m watching indicate the massive oversupply problem is going to be with us through 2011. About 27% of all employment is construction related, and about 35% of retail sales are connected to home furnishings and improvements. GDP may tick up positive in the last half of this year, but there is maybe a 60% (and rising) chance that the economy dips back negative in 2010, and then bumps along a bottom through 2011. That doesn’t bode well for retail in general.
That’s not to say the sector is dead. There are markets where high barriers to entry (e.g. strict zoning and development standards, over-supply, lack of land, etc.), stable employment and positive population growth will insure the long-term viability of centers in those markets.
The key to finding real opportunity for any property type in a downturn is in completing extensive market research. We go way beyond the typical demographic reports of the past, including analysis of the employment base, labor market, government fiscal soundness, school quality, and local tax issues just to name a few.
In our market we’re actively pursuing government and health-care related properties, mostly office, but also special-use buildings. Those are the only two sectors showing growth, and of the two gov’t is poised to expand at the greatest rate in our history.
Credit is tight, but as the TARP money gets sent back to DC and the banks are out from under gov’t regulations things will loosen up. Our lenders are actively courting us to bid on deals, and we’re enjoying the attention. Now is the time to be developing lender relationships so you can act fast when the right property in the right market pops up on the distressed property radar.
Hang in there guys, this can be incredibly profitable if played the right way, but as noted above, it’s going to take work to make it work. For all of my optimistic musings, I am acutely aware that we face significant threats that could change my thinking in an instant. This is a highly fluid situation, with major changes occurring almost daily. It is not the time to be locked into any one mindset. It IS the time to be intently preparing to develop the means of capturing the opportunities.