The business and institutional ecosystem that encompasses commercial real estate — which includes everyone from originators, brokers, investors and lenders to renters, landlords and regulators — have dealt with plenty of boom-and-bust cycles. However, the changes we are experiencing right now appear more profound, leading many to ask, “What if this rebound does not follow the usual path?”
The COVID-19 pandemic produced a financial shock. More importantly, however, it also has changed human patterns and preferences for work, home, retail and leisure. Whether such changes are permanent has yet to be proven. But behavioral science studies tell us that people underestimate the impact of changes on their lives but overestimate the speed at which they will manifest. So, expect lasting change to emerge in these areas. The tectonic plates are still shifting.
Executives the world over are still working to get people back to the office. The truth, however, is that as leases come up, companies increasingly are taking the opportunity to cut real estate-related costs. With office space typically making up about 10% of a company’s expenditures, the chance to save money in this area becomes even more attractive as economic uncertainty means firms are introducing structured cost-cutting programs and challenging cost targets. When having to choose, most company executives would prefer to direct operational investments into technology over real estate.
Seismic events
Even in the past, traditional office-based businesses, which occupied much of the most expensive real estate assets in cities, only used a typical desk or meeting room for, say, 40 hours of a 168-hour week. Post-pandemic, this is often down by 40% to 24 hours, just 14% of the hours possible. This is both a waste of resources and an indicator of a deep drop in underlying value, and hence price risk.
“Executives the world over are still working to get people back to the office. The truth, however, is that as leases come up, companies increasingly are taking the opportunity to cut real estate-related costs.”
Despite many positives, it is difficult to imagine that a focus on futuristic workplace design, flex-working solutions or new technology is going to bring back the demand for certain commercial real estate sectors such as office space anytime soon. This challenge represents a long-term strategic issue for the industry.
Businesses aligned to the major asset classes that have attracted investors in the past are in the middle of these major seismic events. Supply chain and energy inflation have driven up build and operation costs, underlying demand for space has dropped, interest rates have risen, and valuations are subsequently falling.
The outlook remains poor despite what optimistic agents might claim in their research. Lenders and investors are feeling nervous. Commercial construction starts nationwide have fallen considerably and government infrastructure spending is subdued.
Refinancing troubles
Bankers, once again, are set to play a major role defining the route out of this situation. Regardless of the cost of funds, a debt refinancing wall is approaching that must be addressed. In the U.S. alone, more than $2 trillion of outstanding commercial real estate loans will come due by 2027.
Pragmatism will mean many of the winners in the battle for refinancing will be those that already hold the assets. This will be true even if in the worst cases where the lenders are doing little more than “extending and pretending,” a term that refers to the strategy of commercial real estate lenders extending maturing loans with the hopes that market conditions will improve in the future. In Western economies, the social and financial appetite for large numbers of foreclosures is weak after the experiences of the financial crisis of 2007-09.
Holders of mid-grade assets (A-, B+) are most at risk. Top quality assets, especially those with strong sustainability credentials, will retain value, and many Class C assets are already in the hands of owners who do not rely on debt.
Slowing market
In the Eastern hemisphere, most notably in China, where the troubled real estate company Evergrande is located, investors are losing everything, and the political response is sometimes to blame foreign influence. International advisers and accountants have been spooked and future flows of global capital will be more cautious given this experience as well as general geopolitical unease.
This is not to say, however, that money earmarked for foreign markets will be invested in the U.S. There are plenty of grand projects around the world competing for resources. For instance, the unprecedented luxury coastal real estate project Neom, located northwest of Saudi Arabia, is attracting a large amount of capital, talent and supplies.
All of these factors have resulted in the continuation of the hold-and-improve strategies. This may be bad news for those businesses that rely on real estate capital asset trading to make their margins, but arguably good for innovation and sustainability.
Some sectors will perform particularly well. High-end hospitality operations in many cities, for example, are benefiting from a surprising and welcome boom, even if owners have fewer options to trade out of their holdings. Businesses that use the next few years to build capabilities, including technology systems, which enable them to operate assets more productively, will gain a lasting advantage.
Manage and serve
Although the best response to all this will vary from business to business and sector to sector, many tried-and-true business strategies remain the same. Here are a few of the most popular:
Assess and manage balance sheet risks. Work to line up alternative sources of financing if needed (including new equity) and look for deals on real estate holdings that can be sold. Introduce new systems to detect and protect against legal liability exposures. Modern data analytics can help with this last matter, in addition to well-sourced insurance.
Refocus on winning sectors. This may be a gradual process, but businesses that do not alter their strategies now may find themselves behind the curve and in an overcrowded market in the future. Growing real estate sectors that should be explored include distribution and logistics, health care and medical services, assisted living and student housing.
Serve your customers. In a world of easy access to ratings and feedback, excellent customer service will allow some real estate companies to outlive, and even acquire, the competition. There are, for example, new home builders successfully competing by helping clients better manage the financing and move-in process.
Cut costs and improve margins. When it comes to cutting costs, no area of business, including corporate overhead, should be protected. Many large service businesses have seen 30% to 40% drops in activity in high-margin capital markets. Meanwhile their lower-margin, steady cash-flow businesses, such as property management and financial management, have become critical. Extracting greater margins from the smaller units should be a priority.
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Most of these approaches are well within the existing capabilities of real estate firms. The important question is how tenaciously executive boards will invest and pursue such matters. Some of the capabilities they need are new and emerging, especially data analytics and artificial intelligence. All this will take time in an era when demand patterns continue to shift. Treat with skepticism any leadership team that sends out the equivalent of a “mission accomplished” speech from the boardroom. Accomplishing this mission will be challenging and require patience and innovative thinking.
