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It's the Assets, Stupid

Some might say the real estate industry is for dreamers. That's a great thing when you apply your dreams to developments that shape a skyline and a city. But it's another thing when the focus shifts only to the building's projected financials and loses sight of the assets themselves. What is happening in today's real estate market has been a rude, yet much needed awakening. In the end, it's always about the assets.

By Frank Sullivan



The current environment is not unique. It has many similarities to the last major industry downturn in the late 1980s and early 1990s during the Savings & Loan Crisis. For those of us who witnessed that cycle firsthand, we knew the demise was caused by overbuilding, which led to commercial real estate loan defaults and foreclosures. The troubled banks had been very aggressive in financing a construction boom that led to a vast oversupply of vacant buildings across the United States. The fallout was the extremely long projected absorption of this newly-built office space, estimated in some areas like Downtown Chicago, to take almost two decades. Ultimately, this led to a freeze-up of lending for all real estate.


Developers and investors that survived the major decline of the late 1980s and early 1990s were unsure what would be able to replace banks as sources of financing. Life companies could not fill the void alone, commercial banks were for the most part out of the picture and the thrift industry was a shadow of its former self. The answer would turn out to be: Wall Street and the creation of the commercial mortgage-backed securities market.


Financial engineers sliced, diced, structured and brewed financial concoctions that were billed to be safe, sound and secure. After all, the reasoning seemed logical: mix up a lot of different assets and even if a small percentage of them fail, the vast majority will be healthy enough to more than cover any loss. Unfortunately, this financial model failed to take into account real estate cycles and the fact that a sinking tide lowers all yachts.


The result is today's real estate and lending environment now mired in slag heaps of complex financial instruments with no clear way out. Many of the financial engineers who created these lending vehicles are no longer in the picture, and the resulting mess has been left to seasoned real estate professionals to sort out. For these commercial and residential real estate owners and executives, it's imperative to take a step back and remember that what counts are the assets that back all this paper.


These assets are hard, real buildings that are operating properties and must be leased, managed, operated and maintained. They are dynamic properties, not static or passive documents. Those who own these assets are responsible for the life, safety and care of its occupants and users. The buildings' tenants are businesses, companies and residents who have ever changing needs. As physical assets, buildings require care, maintenance and improvement to maintain viability.


How a property is viewed by a real estate owner, manager or leasing agent is very different from an investment banker or loan underwriter's perspective. Real estate executives notice specific attributes of the property like ceiling heights, column spacing, layouts and mechanical systems. For example, take a loan underwriter into a boiler room and most will observe if it's clean and well-maintained. Enter the same boiler room with a building operator and they see the capacity, efficiency and condition of the mechanical systems and other moving parts of the asset. Furthermore, tour a property with leasing agents and they highlight the specific features that appeal to existing and potential tenants, and what obstacles need to be overcome relative to the building's competitive set. Walk the same property with a banker and their primary concern is confirming the tenants in occupancy match the rent roll.


On a recent visit to a regional mall, a tour with the property manager demonstrated first-hand how the ability to analyze an asset's minute details can help real estate owners protect the value and best position the property. The manager pointed out seven different shops selling women shoes and described each retailer's profitability ranking. Outside the lowest producing store, he discussed the unsuccessful management and operations of the retailer, highlighting as an example how the store had not changed its window in more than three weeks. Specifically he stated, "We know we can do more sales in this category, so we're not going to renew this lease when it's up, and if we can get them out sooner, we will." The manager's insight and experience led the mall owner to replace the underperforming retailer with a more profitable tenant.


My tour of the mall with an expert manager presents a clear distinction from how many CMBS loan originators have approached the real estate market. Simply, when they tour the space, they focused solely on the financials. They reviewed rent rolls, historical and current financial statements and analyzed how much income is available to pay debt service. They discovered the use of interest-only lending to enable even larger loans. Of course, they became so competitive and overly-aggressive that projected rent increases on rollovers were used to justify higher cash flows and therefore larger loans. Any projected shortfalls in debt service were covered by creating reserves estimated to be sufficient to pay these deficits until the assumptions of ever increasing rental income became reality.


The fallout of this financial approach to dealing with tangible real estate assets is now affecting investors across the country and internationally. Ultimately, the market is not going to engineer itself out of this mess. The smart owners, investors and developers are those who will get control of the assets and appoint a team to reassure tenants, improve the income stream and take the appropriate steps to preserve the property in a way that protects and enhances its value.




Frank Sullivan is a principal at Gallin Glick Sullivan O'Keefe. 




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