A&D 2016 Meeting Report: Adaptation is the Seed of Evolution

Posted on March 30, 2016 in Viewpoints by admin

_L2A8347“The only way to predict the future is to have the power to change it.”

– Eric Hoffer

For a print version of this report, click here.

In January, NAREIM hosted its annual Acquisitions & Dispositions meeting at the Mr. C hotel in West Los Angeles. Set on high on a hill at the southern tip of Beverly Hills, members could easily survey the fast-changing downtown Los Angeles skyline adapting to a new generation of users and purpose.

At its core, real estate is about adaptation. “Every form of real estate is an adaptation of something else,” proclaimed Gunnar Branson, President of NAREIM, in his introduction. “A theater is nothing more than an adaptation of a hillside. An office is nothing more than a meeting place adapted from a street corner.” We build on what already exists, improving, piece by piece, inch by inch, to cross vast distances, perform grand transformations, and ultimately end up where we always wanted to be: Greenwich Village.

SoHo and the Village encompass some of the most desired and expensive real estate in New York City and therefore, the world – and yet as recently as the 1960’s and 70’s it was considered junk. Small and inefficient streets, old buildings designed for a different time and uses, factories and warehouses built before electricity even existed; it was difficult to imagine it having any value. Robert Moses almost succeeded in turning SoHo into the Lower Manhattan Expressway.

He didn’t succeed…and in a short period of time, new generations of artists, entrepreneurs, and others adapted a “useless” collection of old, tired buildings into something so important and valued that other communities and buildings often try to imitate or look like that useless neighborhood of old New York. Who would imagine 50 years ago that today we would see new apartment loft complexes built in downtown Houston fashioned to look like 19th century warehouses?

_L2A8724Who has the power to shape the future?

Maybe it’s the investors, maybe it’s the builders, and maybe it’s the consumers, but the only way to know is by looking at the numbers. “US consumers aren’t spending like we expected them to,” says Chris Macke of American Realty Advisors, “but they may in the future. A growing dollar and strong economic performance suggests that the power is there, but the sentiment is not.”

There are two economic players out there that have to be considered: Us and them; The US and the rest of the world. The US economy is number one in the world and is as strong as it’s ever been. That is based largely on our interaction with the number two economy: China. “Over the last 10 years 40% of all energy consumption growth has occurred in China. About 30% of global economic growth has been Chinese as well. So they are a very real player. In addition, they are trying to transition to a consumption based economy as opposed to an investment based one. They are trying to liberalize their financial markets to open the door to foreign investment. And they are trying to devalue their currency without causing too much disruption. If Greece tried this, that would be one thing, but China is the second largest economy in the world.” If they succeed in any one of these goals it will have a serious impact on the world economy. “China is looking at US real estate as a ‘Bank Alternative’ investment,” says Macke, “So if they can invest now and get their money out later that will be great, but if this goes over a cliff and something happens that means the Chinese can’t get their money out, that will be a problem.”

Is now the time to be aggressive or conservative?

“This is the question that keeps me up at night,” says Macke, “Do I focus on maximizing returns and letting a bit more risk into the mix? Or do I prioritize the risk and accept the yield that comes with my risk limit.” To “core” or to “value add”, that is the question. “There is a good chance that we will get cut short on value add deals because even quick ones take two to three years, and there is more room to go down than up, economically.” With respect to planning for the impending downturn, real estate offers safety, a calm port in which capital can ride out the storm without too much loss. “We are leaning more towards the conservative side, but if the benchmark is getting aggressive how do you balance? Capital has a very short memory so when you aren’t offering the highest return the money goes elsewhere.”

Multi Family: Condo or Apartment?

“We are generally positive on rentals,” says Michael Cohen of CoStar, “since 2006 or so there has been a downturn in home ownership, and a considerable increase in rentals.” But what is the driving factor there? Is it separation of wealth? Low wages? Millennials? “The greatest increase in rental households has been in the 50-60 year old demographic. So urbanization is actually driven by middle-aged people, not millennials.” Another factor is mortgages. “50% of all mortgages went to people with an average Fico score of 780 or above. That’s a pretty high score and does not favor home ownership for younger people.”

Urbanization: Where is the next Williamsburg?

“Follow the nerds. New tech jobs indicate future urban growth areas,” claims Cohen. Places like Austin, Brooklyn, and San Jose have grown, and now that growth is migrating to new urban areas. “Most suburbs are seeing a decline in density and average household wealth, where urban areas are seeing increases across the board.” There is more multi family construction now than ever before, 50,000 units per quarter to be exact. But is that sustainable? “We are beginning to see a slow in the leasing numbers for some of the new construction,” notes Cohen, “and, if you look at the numbers 55% of all new construction demands an income of $75,000 a year or more. Look at downtown LA: It’s flooded with new construction that demands a high income. However, the median income in that area is $28,000. So, the developers are counting on tenants coming from outside these sub-markets.”

“But with respect to Downtown LA, I think if you build it they will come. There is demand there,” argued Gavin Hinze of CBRE.

_L2A8760How is the workspace changing?

In the past, most corporations have assumed that if a potential employee has a degree and wants a job, the job itself is sufficient to attract and sustain them. “In the 1980’s big law firms started creating work space environments to specifically attract the top law students because they were in competition for them,” says Paul McGunnigle of Howard Building Corp., “Now you see many companies doing this and it’s the biggest change I’ve seen in a long time.” The look of a workspace is incredibly important. Dark wood, glass walls, and expensive art characterized the great law offices of the 90’s. However, what employees see is only part of the equation. These days what you feel is just as important.

that demonstrably improves the quality of life and productivity of your employees, clients are going to demand that,” according to Edmund Novy of PMRG, contractor for American Realty Advisors. For it’s encouragement of that demand, and on behalf of the US Building Council’s Los Angeles Chapter, Novy awarded The Green Leadership Award to NAREIM for it’s leadership excellence in support of effective sustainability practices in the built environment.

Everyone has heard of the LEED rating system that measures and certifies how healthy a building is for the planet. An equally important, if lesser-known, building certification is the WELL Building Standard, pioneered by DELOS, and implemented by the International WELL Building Institute. “What WELL does is it measures the built environment’s effect on the people inside the building,” explained Jennifer Berthelot- Jelovic of ASAP, “Whether it’s employee attraction, retention, or even decreasing insurance premiums, the WELL Standard improves the bottom line.” Buildings with LEED certification have become de-rigeur for improving energy and water efficiency, but WELL certified buildings could actually lower the cost of salary benefits by improving the health and efficiency of the workforce itself.

What is the downside?

“There is a fair amount of cynicism around sustainability,” says Gavin Hinze of CBRE, “what if the improvements you make today are obsolete in three years? Then you’ve just wasted your money.” Fads come and go. 10 years ago sustainability looked like it might be just a passing fancy, but the numbers show that if this is a fad, it’s a very strong one that will be around for a while.

“Back in 2005 only 1.5% of buildings were Energy Star or LEED certified now almost 40% of all buildings have one if not both certifications. That’s pretty dramatic,” says Dave Pogue of CBRE, and the bigger the building the higher the ratio. “If you’re over 200,000 sq. ft? You better be paying attention.”

“If you’re in the institutional space it’s no longer a conversation, it’s a requirement,” says Peter DiCorpo also of CBRE, “these investors are very up to speed on sustainability and they basically demand it.” So the real downside is not potentially wasting your money on sustainable innovation, but rather the loss of business from not investing in this technology.

How far is too far?

There are many relatively cost-effective ways to get to LEED certification, but getting to the maximum level can be exorbitantly expensive. Similarly, attaining the top level WELL certification may not be the most cost effective or beneficial thing to so. “LEED was primarily designed by architects for environmental reasons, but there is no way to ask the environment what it wants most,” noted Pogue, “However, with WELL we set up a study and found that the number one thing that people wanted is air quality and number two is natural light. All the rest of it is secondary.” So it seems that there is great opportunity in achieving some LEED and WELL certification, but there are diminishing returns the higher up the scale you go.

And yet…a recent study by MIT Research Scientist Dr. Andrea Chegut suggest that the overall costs of building new construction to green standards is close to par with traditional modes of construction, (See “On the Cost of Building Green” at www.nareim. org). The cost of achieving even the highest standards may be coming down, even as we raise those standards further.

_L2A8732How is Capital Changing the rules?

“Foreign capital wants to be involved but they are generally uneducated on the asset class,” says Peter DiCorpo of CBRE. With recent changes to US policy they can be involved more now than this time last year but that doesn’t mean they know what they are investing in. So there is a lot of education that goes along with raising capital. However, “once they get it, they want the same thing over and over. If it works once they want it 20 times,” according to Derek Landry of CBRE.

“There is a disproportionate amount of capital flow to the larger managers, which is due in large part to new regulatory measures,” says John Lee of Pimco. “You can attribute that to the SEC or to LPs but certainly there is a higher standard.” With the added regulatory pressure on funds its very difficult to be at the mid pack or startup level because it takes a whole department to insure compliance. “There is a lot of headwind.”

So what do we do? We adapt. If there is a headwind, you rev up the engines and burn more gas to get where you are going. Then you build a more aerodynamic plane. If there is demand for sustainability and environmental improvements, you retro-fit just enough to keep the tenants happy. Then you build a fundamentally better building. We, the managers, are not in control of the prevailing wind, but we are in control of how we set the sails. Usually the money has the most say, the consumer has the final word, but money can only buy what is on the market. Voters can only cast their ballets for candidates who have chosen to run.

So who has the power to shape the future? The builders or the buyers? The investors or the tenants? Maybe it’s not a class of people. Maybe it’s a class of decisions: The bold decisions, the educated decisions, the brave decisions, and when we choose to make those types of decisions, we choose to have the power. When we don’t, we choose to give the power away.