Viewpoints

A&P 2016 Meeting Report: Real Estate is Adaptation

Posted on August 31, 2016 in Viewpoints by admin

Baseline (last page right)-2“It is not the strongest species that survives, nor the most intelligent, but the one most responsive to change.” – Charles Darwin

(For a print version, click here.)
Commercial real estate, just like every other industry, is changing dramatically, and forces from the way people use real estate to the way investors want to put their capital to work is demanding that investment managers adapt smartly and quickly.

“Fortunately, human beings can be really good at adapting if we let them – and not impose too much of our own egos or visions upon them” noted Gunnar Branson at the 2016 A&P meeting in Atlanta, Georgia. Think about how cities are really a constant adaptation of what there was before. Buildings and neighborhoods are rarely used for their original purpose for more than a few decades – and as they age, and new generations make adaptations, the cities become ever more vibrant, ever more unique, and ever more productive.

Meeting attendees saw this first during a tour of a transformed mid-town Atlanta where a new and unique urban landscape is emerging from a post-industrial southern landscape. Most notably, the group walked a mile through an abandoned industrial rail corridor that encircles the heart of the city that has become the BeltLine, a walking and bicycle trail that connects neighborhoods, retail, residential, entertainment, office and even light industrial. Despite an abundance of good quality residential ground-up construction, most compelling was the adaptation of existing structures all along the path – warehouses turned into web design firms and micro-breweries, distribution centers turned into restaurant incubators, and loading docks turned into viewing decks. Instead of planting a sparkling clean version of a suburb into the city, the development is guided by the adaptation of what is already there. One example in particular was quite fascinating: the Ponce City Market, a live/work/play environment created in a 2 million square foot Sears distribution center which had sat abandoned for decades. Thanks to easy access to mass transit, bicycle trails, and walkable retail, many residents do not have cars.

Take a moment to think about that – someone living in car obsessed Atlanta going without a car? This is a strange new world indeed – and the real estate owners along the beltline have adapted and profited well from it.

Baseline (first page center)In addition to the built environment, we must adapt to changing desires and needs of the investors. “Capital wants things that we are not delivering,” Branson pointed out, “It wants to know more, control more; it wants to make more money but pay less fees.” It’s not up for debate. “We are not going to win this argument. We have to find new ways to adapt. We need to look around at other businesses and learn from their adaptations or their failure to do so. We need to figure out a way to evolve and satisfy their needs.”

Where are we in the cycle?

Brian Bailey brings over two decades experience of real estate industry experience to the Federal Reserve Bank of Atlanta. Brian and others are contributing to Fed policy formulation by providing a deep understanding of how real estate works and what it means to the economy. “By the time you look at construction spending, salaries, and ancillary costs, real estate represents roughly 6-7% of GDP,” according to Bailey. “So real estate significantly shapes our economic policy.”

What is Bailey and the Fed looking at right now? A few trends and data points stand out:

“We are approximately at the 79th month of the expansion, which is above the historical average of 60 months. However, the last four expansions have averaged 90 months, so the cycles appear to be trending longer.” Although the overall U.S. economy continued to expand moderately through the first quarter of 2016, foreign events have been a headwind. Net exports and non-residential investment weighed on GDP growth in the most recent quarter. Wage growth has occurred but the gains have not been uniform across all sectors of the economy; some areas are experiencing a pronounced slowdown due to exposure to energy industries. Generally, the health of the consumer remains resilient, as evidenced by continued declines in seriously delinquent home mortgages rates.

“The best loans are made in the worst times, and the worst loans in the best times.” Lending continues to grow in the midst of an evolving market environment. There is growing risk in some markets and property sectors, which has implications for the commercial real estate (CRE) and CRE finance communities. Current CRE activity is most robust in multifamily, where apartment completion rates in several submarkets are well above historical norms. “This is the first recovery that hasn’t been led by office,” noted Bailey.

Although market metrics generally continue in a positive direction, any increase in appetite for risk remains a potential concern. “If you ask developers, they’ll tell you that the current landscape is nothing like what was seen in the 1980’s and 1990’s, so they see a real opportunity to build now.” But build what? Apartments are being built at a 40% higher rate than average and hotels are building at about 4% over the norm. In contrast, office and retail construction activity is at levels 30% and 59% below average, respectively. This begs the question, where are these people working and shopping? Does the increased demand for shared office really account for an almost 60% decrease in construction? On the flip side, “if wage increases are growing at 3% how can people afford double-digit apartment rent increases?” Markets are sending conflicting messages.

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Foreign capital is streaming in from all corners of the globe. We’ve all witnessed the influx from Asia and Europe. People are putting their dollars in long-term storage here in the U.S. market. “If someone comes in and wants to pay 30% above asking price, I’d want to understand their motivations and intentions,” said Bailey. However, it’s hard to turn down the highest bid. “The real question I have is how long is the money going to stay? Will it be fickle like the Japanese investments of the late 1980’s? Or is it really here long term.” The answer may have a significant effect on the future CRE landscape.

How Can We Streamline Data Collection?

No matter what happens in the market, a persistent pressure on the operations of investment management is the demands of capital – whoever or whatever it comes from, for higher transparency, higher efficiency and lower cost. And this industry needs to get its data collection and reporting in order but how to proceed? What should we do to fix it?

“Which comes first: the data or the questions?” Asked John D’Angelo of Real Foundations. How can we more effectively deliver data up the chain of command? For the bulk of the formative years of commercial real estate management the industry has existed largely on gut feeling. A manger would gather up spreadsheets and make a judgment call: Buy or wait, sell or hold, hundreds of millions of dollars. “So we really had a data problem. If an issue arose, everyone would stay late, stare at the data, and try to figure out what the exposure was. Not as a result of bad management but because the data was unclear. We were doing too much hunting and gathering.” Each manager had good data on their own assets, “but all that data was sitting on a desk” unattached to the rest of the company.”

“The first question we have to ask is: are we all on the same page?” Says D’Angelo. “At one point I asked a group of co-workers to define NOI. Turns out, they all had slightly different definitions.” So the first step to streamlining data collection is making sure that there is a stated and standardized vernacular.

According to Bhody Hedgcock, SVP of Clarion Partners, “If you ask five different brokers what the vacancy rate is in a particular market, you’ll get five different answers because there are five different definitions.”

“Real Estate is largely a prediction business,” pointed out one participant, “We are investing based on what we think is going to happen in seven to ten years.” Much can be learned from other businesses based on prediction. Before meteorologists started collecting massive amounts of data and letting the data charts show how the future will unfold, weather was exceedingly imprecise. Although they don’t always predict it accurately today, they have been able to improve predictions extraordinarily. If the weather man tells you there is a 90% chance of rain tomorrow, most people would wisely bring an umbrella. What would happen if real estate started collecting more data and perhaps improved its predictions by even 20%? Would that be a good thing to do?

There is so much information available these days, the question is how to best parse it? What does the amount of cars coming and going form a shopping center parking lot tell you about the performance of the underlying REIT? There are objective stories buried in data. The more we can get our subjective viewpoints out of the way and let those stories shine through, the more effective we will be. Rather than thinking, it feels like it is going to rain and then looking for the evidence to prove that hypothesis, we should let the data do the talking. It will tell us much more accurately if rain is on the way or not.

Why Does Sustainability Matter?

There’s one area in real estate where new data is being created and collected every day: Sustainability. There are multitudes of rating, tracking, and benchmarking systems: Energy Star, LEED, WELL, Green Globes and GRESB just to name a few. There are emerging and highly successful commercial real estate service companies based around sustainability like Green Generation Solutions and Goby. There are those in CRE investment and management who still struggle with the value of sustainable construction. Beyond a fuzzy feeling deep down that comes from knowing that the properties with the highest ratings will be best for the planet and the people inside, does it really influence the bottom line?

“Traditionally ESG (Environmental Social Governance) applies most in new development, when considering the lifespan of a building,” Says Neil Pegram of Morguard, “but it should also be considered in acquisitions and operations.” Sustainability is in everything. It’s in the initial construction, the deals, and the management of every manager’s AUM. Retro-fits and intelligent supervision will extend the lifespan and the value of a building.

“This matters globally. In the UK there is a new building code that forbids constructing or trading buildings deemed inefficient,” according to Lisa Lefave of HOOPP. So that fuzzy feeling will be required by law in the UK in coming years and they will most certainly not be the last to implement such measures.

“CAL-PERS just came out with a large scale profile about the ‘Band-Aid’ on sustainability there,” mentioned Hedgecock. They are using sustainability ratings as a way to gauge where to invest. So that fuzzy feeling will get you more capital from one of the largest and most influential pension funds in the country.

Long story short, it’s not just a fuzzy feeling. It is a significant part of the future of real estate.

Is Walking Part of Building?

On the mid-town tour NAREIM members viewed the new Beltline pathway, Atlanta’s answer to The Highline in New York. This was meant to be just a stop along the way. There was a luxury bus waiting to ferry the 35 members, dressed in business attire, to The Ponce City Market roughly 1.5 miles away. But a strange thing happened; The entire group opted to walk instead of ride in an air conditioned, leather clad coach. “As we walked we observed new restaurants, shops, bars, apartments, and art installations,” commented Phil Lukowski, EVP of Waterton. We saw everyone commuting, exercising, and developing businesses around this pathway. “Here was this huge group of people in suits and ties clogging the system and people were just smiling and going around us.” The highlight of the bus tour was the part that wasn’t on the bus.

The newest and most vibrant development happening in Atlanta surrounds this pathway. “The 22 mile Beltline loop is responsible for the rehabilitation, preservation, and development of 15,000 acres of land,” Says Paul Morris, President and CEO of Atlanta BeltLine Inc. (ABI) “That’s about 20% of the city.” ABI is a private developer and not part of local government. “After the great financial crisis, Atlanta was one of the top four worst hit metropolitan areas. We are coming back strong and are seeing a shift in the demographic of the city towards Millennials.”

Baseline (first page right)Jim Irwin, President of New City Properties, was one of the visionaries that saw potential in a 2 million square foot abandoned Sears factory along the BeltLine that is now Ponce City Market. “I used to take brokers through this vacant filthy building that had been abandoned for over a decade and say, ‘this is going to be Atlanta’s first Class-A loft office space.’ Recalled Irwin, “they laughed at me.” Ponce City Market now commands the highest rents in the entire city.

Young people are moving to urban areas. We are seeing this across the country. They are not interested in purchasing cars, houses in the suburbs, and commuting to the city for work, at least not yet. They are concerned with sustainability, both their own bodies and that of their surroundings, and great way to improve both environments is to drive less and walk more.

There is rediscovery in adaptation. Five years ago an expert on the Atlanta market confidently asserted that nothing would ever happen south of Buckhead. But with a little investment and a lot of adaptation, it has quickly become one of the most interesting and magnetic urban areas in the country. “You can almost see the property values rising,” mused one participant.

Things change so quickly. Are you adapting?