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The worst of times? A tale of two cities.

We all know it is not the best of times, but few will admit that the worst of times may still lie ahead for real estate. The real estate industry did not do well in 1992, but then nothing did. Like much of the country, real estate used a weak economy as an "escape all" for poor performance. It is easier to blame a condition over which there is no control than to confront the real problems. Once the economy improves, however, real estate's problems will remain and must be addressed.

The biggest single problem that owners and property managers confront is an abundance of available commercial space. Almost every major city suffers from a glut of office buildings, as are many second- and third-tier cities.

When a city is overbuilt, the local economy is weakened by the stagnation of construction. The weakened economy, in turn, depresses the real estate market still further, and the downward spiral continues.

The question is often asked, "How long will it take for the commercial real estate market to recover?" In truth, no one knows. But if the experience of building owners and managers in Texas and Colorado is any indication, the best of times may be a long time coming.

In past downturns, many owners have seen the condition as short lived. Their reaction to a soft market was to batten down and make it to the next year, when things would get better. In reality, the "next year" is many years away.

Neither the abundant space nor the local weak economy is short term. The property manager and owner need to recognize that they are riding out a prolonged cycle, which requires a different, long-term strategy to maximize the value of the real estate.

Although Texas and Colorado are now beginning to recover, it was a ten-year process--a ten-year trial by fire that is still not quenched. By drawing on the experiences and tools of managers exposed to these markets, hopefully property managers now faced with similar conditions in other parts of the country will be better prepared.

A little history

Houston and Denver first recognized the soft real estate markets in 1982-83. A market review in the November 1983 National Real Estate Investor declared 1983 the worst year in Houston since the Depression, with vacancies at 28 percent, while Denver reported office vacancies of 20 percent.

Two years later, Houston was reporting record gains in leasing, although its CBD office vacancies were still 26 percent, the highest in the nation. Likewise, Denver was describing growing absorption that lowered vacancies to 22 percent.

By 1987, Houston was predicting that "the worst is over," while George Thorn, president of VRG Development, predicted at the city's Mile High Real Estate Conference that Denver "would have no more office space available by 1990." Obviously, real estate remains a very optimistic business.

While Houston's commercial vacancy rate has decreased, rental rates have not significantly improved and have actually fallen in some submarkets. Denver's real estate market has stabilized and is pointing towards an upswing, yet the "overall" office vacancy rate, which includes sublease space, is still 20 percent.

Unfortunately, the real estate managers in Denver and Houston did not read the signs; they assumed the storm would pass quickly and just tried to ride out the hard times. The results were often failure and bankruptcy. When a person knows the eye of a real estate "hurricane," he or she can prepare to weather the storm. Three steps are necessary:

* Analyze and project the local economy for a realistic projection of recovery.

* Analyze and project the real estate market to determine your property's current and future occupancy.

* Develop a long-range "survival" plan.

Recognizing the true conditions affecting a soft real estate market, current and future, and devising a plan to cope with those conditions will enable the property manager to focus and function more effectively. Without this approach, both the property manager and the owner will experience frustration and a feeling of helplessness as they grope through years of competing in a "sea" of available office space.

The local economy

Before you can decide how best to protect your building from the downturn, you must look at the big picture. Determine the projected annual growth in your area. Where and how will this growth occur? Factor in major known shut-downs and cut-backs such as the closing of government operations or businesses that will impact the real estate market.

Often local economists releasing their growth projections for a depressed area will paint a rosy picture of the real rate of growth in the name of public relations. Compare several sources of data to arrive at a consensus for forecasting.

The local real estate market

Next, compare the performance of your building with local real estate conditions. What is the amount of vacant space in your city? In your sub-markets?

Identify potential sublease space that may enter the marketplace. A substantial amount of sublease space can seriously impact the market in a relatively short period of time. If the local economy is depressed for an extended period, sublease space will appear as businesses experience cutbacks and failures.

As oil companies began their cutbacks in Denver in the early 1980s, they tried to sublet large blocks of new Class A office space. As suppliers felt the effect of the cutbacks by these oil companies, more sublease space became available. In 1983 Denver had over 1 million square feet of sublease space available with rents a minimum of $3 less than any comparable space (Denver Post, March 30, 1983). In 1991, more than 800,000 square feet of such space still existed.

Determine the true annual absorption rate. Is it positive or negative? Use a realistic economic growth factor when calculating projections. Pockets of a city may report positive absorption while the city has negative absorption overall.

In the mid-1980s, Denver commercial tenants were coaxed from one sector of the metropolitan area to another. The net effect was zero or negative absorption because in many instances the new space occupied was smaller than the space vacated. Strong leasing activity did not reduce the overall available space.

The movement and attitude of tenants also affect space. If a great deal of Class A office space is available, rates will decline to the point where tenants of the Class B buildings move up to the A buildings. In fact, the rate spread can become so compressed that almost any tenant can afford A rents.

Projecting absorption brings the real market condition into focus. In 1986 it was estimated that the entire population of the city of Cleveland would have to have been relocated to fill Denver's vacant office space!

Not all absorption is negative in a depressed market. Nationally office space per employee increases as office vacancy rates go up. In 1978 the average was 170 square feet per person in Denver; in 1986 it was 276 square feet, with oil companies topping the list at 320 (Ross Consulting Group, February 11, 1986).

Develop a long-range survival plan

Research and analysis on the local economy and local real estate market are essential preliminaries to developing a long-range survival plan for a property.

An estimate of the time needed for a region's commercial market to stabilize and recover is the plan's foundation. Be conservative; underestimating the length can jeopardize an owner's capital value and cash flow. In addition, if high vacancy rates exist, market competitiveness will become more and more intense as the depressed state continues, forcing further concessions on owners and managers.

Involvement of the property owner is paramount in developing a long-range plan. The owner must recognize what ultimately will occur in the market. Many owners fail to admit the true state of a soft market in the beginning. As a result, their buildings stand empty longer.

Both owner and property manager need to acknowledge that they face a consumer-driven marketplace and that the law of supply and demand is the underlying factor. Not only must a price-competitive product be offered with marketing incentives, but the building also needs to improve its existing services and perhaps to provide added services to retain and attract tenants.

In a severely depressed real estate market, the approach to the bottom line must change very rapidly for the building to remain competitive. The question often becomes: How long can the building operate with a negative cash flow, and how are shortfalls to be funded?

Capital to fund negative cash flow will be hard to obtain. Many limited partnership agreements prohibit cash calls from limited partners. Developers, general partners, and private investors are generally reluctant to part with any more cash. Institutional owners may have the capital, but will not release it until a complete management plan has been submitted and substantiated.

One solution is to renegotiate the financing. Waive or defer debt service, pay interest only, restructure, or refinance. As foreclosures and receiverships become more commonplace in an area, some lenders may be more willing to consider a workout, while others would prefer to foreclose so as to exert total control over the property. In any case, lenders will require the involvement of professional management during a workout.

Working with a lender that has taken back a property presents a different set of circumstances. Bodie Beard, CPM |R~, president, Bodie Beard Interests, Inc., Houston, comments:

"Based on historical involvement with institutional clients, I observe that clients may alter their goals and objectives based on their initial inspection. A client is dependent upon a manager to use his or her entrepreneurship in making the property more marketable, thus bringing it to its highest and best use. Expect increased communication and more frequent inspections by the client.

"The manager should also anticipate the preparation of both an operational and capital expenditure budget. During the initial inspection of a property in receivership or taken by foreclosure, be observant of those items of deferred maintenance that, if they were to be corrected, would take away ownership's risk of liability."

First, cut costs

Even if a property is not foreclosed, the property manager will be pressured to control costs at every level, particularly those costs associated with energy, governmental regulations, hazardous substance handling, and liability. It is possible to control expenses and obtain the best pricing for certain services by negotiating contracts based on occupancy.

Janitorial service, for example, should be contracted for based on only the occupied space, public areas, and periodic cleaning of the vacant space. Accept bids based on the entire building being cleaned as if 100-percent occupied; then negotiate the contract using the per-square-foot costs quoted for the current occupied space and public areas and the quoted reduced rate for the vacant space. At the same time, care should be taken not to diminish or eliminate any essential services which could cause vacancies to increase.

Real estate taxes should always be questioned. New, vacant buildings may be valued as if fully occupied at a rental rate achieved when the market was at its highest. Contesting the tax assessor's valuation and requesting an adjustment to reflect current market conditions is a positive action the property manager can take.

Should an owner raise the need to cancel the management contract because of a lack of cash flow, consider how to restructure the agreement to lower the cost and retain the management. Perhaps the answer is to provide selected management services. A menu of such services can be presented on a line-item cost basis.

Another method might be to reallocate when the management fee is paid. Jim Aamot, CPM, principal, JCA Property Management, Denver, recommends: "Consider a graduated fee if the building is either vacant or at low occupancy. The structure could reflect a lower fee in the beginning and a gradual increase as a predetermined occupancy is achieved. A guaranteed minimum or participation in leasing fees are also options to consider. Penalties for cancellations are also appropriate with a graduated fee. Performance bonuses, perhaps a percentage of the amount generated in excess of breakeven, are another option. Owners need options, too. Working with an owner may well ensure a client for life.

In addition to an operating budget and long-range cash flow projections, the preparation of a long-range capital improvements budget is necessary for managers facing extended poor markets. Allocate the improvements or major repairs over the projected downturn, prioritizing those most essential for leasing, tenant retention, and operations.

Think long term. Denver's real estate market is just beginning to recover after ten years. However, resist the temptation to eliminate capital funding in the face of low cash flows. Building deterioration will be the result.

Never cut service

With low occupancy, the tendency is to concentrate on leasing. Often ignored is a tenant relations and retention program. Certainly this was a lesson learned in Houston and Denver in the 1980s, and later confirmed in Managing the Future -- Real Estate in the 1990s (IREM, 1991) when the property owners surveyed ranked tenant retention abilities as the most important task property managers perform.

During the 1980s, property managers and owners in Denver and Houston were scrambling to retain existing tenants. Those buildings that experienced the greatest loss of tenants failed to recognize the need to improve or even to increase the services and amenities for existing tenants.

Review the building's tenant relations program. Brainstorm with the leasing and property management staff to decide what services, particularly those of a low-cost/no-cost nature, can be implemented. Concentrate on those that bring immediate and long-term benefits and create good will with tenants.

Low-cost or no-cost gestures--such as a complimentary subscription to the Wall Street Journal, or flowers, coffee, and Danish upon move-in and on lease anniversary dates--often pay real dividends. Retailer discounts and increased concierge services will appeal to employees. Offering a space planner without charge may be what is needed to keep a tenant, particularly during a tenant's internal reorganization.

Survey frequently in person and with questionnaires to find out what services are important to the tenants and how existing services can be improved. Also keep abreast of what the market and competition are providing.

A Denver office building was having great difficulty leasing due to its remote location. In order to provide services to the tenants otherwise unavailable in the neighborhood, the property manager leased the building's first floor space to retail merchants at below-market rents.

Market and economic research provided the basis for determining which year a future market upswing could be anticipated. The expiration of these retail leases coincided with this projected upswing, thus providing for re-leasing at future, more favorable market rents.

Negotiate sooner rather than later

A lease renewal program which initiates negotiations with a tenant long before the lease expiration is a necessity. Begin negotiations in the third year of a five-year lease. Be prepared to provide renewal incentives so tenants do not go elsewhere to find them.

One way to deter a shift is to renegotiate and extend the lease, adjusting the rental rate to market and providing renewal incentives such as additional improvements. An argument can be made against lowering a rate locked in by a lease, but when comparing the costs of retaining versus obtaining a tenant, renegotiation is the only solution.

Steve Wennerstrom, CPM, president, Vantex Realty Services, Inc., Denver, suggests negotiating the renewals two years out:

"To be effective this method assumes the ability to extend the lease a minimum of three years. The procedure involves negotiating a rental rate which is a blend of the market rate and the difference between a tenant's current rate and the market.

"Determine the difference in rent over the remaining term between the face rate of the lease and market (i.e., that portion of current rent that would not be paid if rent were merely adjusted to reflect the market). Amortize this amount, with interest, over the term of the lease, including the extension. To arrive at the blended rate, restate the amortization as an amount per square foot, and then add it to the market rental rate. Here is an example:

Assumptions

Rentable area: 1,000 square feet

Current rent: $18.00 per square foot

Market rent: $12.00 per square foot

Term remaining: 24 months

Term extension: 35 months

Prime rate: 4%

Amortization

Current rent less market rent, per month:

($18.00 - $12.00) / 12 = $0.50

Amortized amount over term remaining: $0.50 x 24 x 1,000 = $12,000

Monthly payment, 60 months at 6%: $232.00

Payment amount per square foot per month:

($232.00 x 12) / 1,000 = $2.78

New Rental Rate

Market rent plus amortization:

$12.00 + 2.78 = $14.78

"The benefits to the tenant include an immediate reduction in rent while taking advantage of current market conditions. The benefits to the owner include negotiating in a less competitive environment, which should result in the highest possible renewal rate."

Tenants are very attentive in lease negotiations that include a cash savings for them. Today, many tenants face a capital expenditure for compliance with the Americans with Disabilities Act. Consider absorbing what would normally be a pass-through cost for the public areas or assisting with the expense that tenants incur as an incentive for renewal. Providing ADA improvements also helps to preserve value for the building owner.

Other areas to negotiate at renewal are pass-throughs and rent escalators. For existing leases in a depressed market, either the CPI increases will not be addressed or only a percentage of the increase will be exercised. If they exist, rent escalators can be used to achieve a beneficial restructuring of the lease.

In Denver and Houston, a number of tenants that had received free rent at the beginning of their leases vacated immediately after the end of the rent abatement period. The more unscrupulous tenants were back renegotiating the lease rates and terms with the proviso, "Adjust the lease, or I'm leaving."

As more tenants tried this technique, owners took different measures to discourage the movement. In Houston, some owners began amortizing the rent abatement over the lease term; in Denver, owners refused to give any rent abatement. A personal guarantee was often required.

As an alternative, some Denver owners required a tenant to sign an agreement imposing a penalty equal to the rent abatement and/or concessions plus interest if the tenant vacated prior to the end of the lease term without the landlord's written permission. The agreement also included a clause which escalated the balance of the rent due under the lease, with full payment due and payable immediately should the tenant vacate prior to the end of the term.

Houston developed a similar agreement requiring tenants to pay a percentage of the unpaid rent and unamortized tenant improvement allowance. Yet, the terms of these agreements were often unenforceable, and if the credit did not exist, the landlord remained in a poor position.

When should a rent abatement be given--at the beginning or over the term of the lease? Most tenants prefer rent abatements at the beginning of the lease. Owners, however, have different needs which must be considered on an individual basis. Owners can benefit from spreading the rent abatement because it creates a constant income stream immediately upon occupancy and presents less likelihood of the tenant vacating prior to the lease termination date.

Owners of new buildings operating with construction financing will structure rent concessions at the beginning of the lease because of permanent financing requirements. With rent abatements provided up front, the leases reflect the pro forma, per-square-foot rents required by the permanent lender to fund the permanent loan.

Rent abatement also affects the value of a building. The duration of the effect is what must be analyzed. After the owner has absorbed the first 12 months of rent abatement, value is stabilized for 9 years on a 10-year lease. Spreading abatement over 5 or 10 years diminishes the building's value. This option is not desirable if refinancing or sale is to take place in the remaining 9 years.

After all the analysis is done, often there is little choice but to provide whatever the market is offering in order for the building to remain competitive. Be open and objective to every proposal.

Offer other options

In addition to free rent, soft markets may require other types of leasing concessions. These may include sizable cash up front, rent abatement, increased and lavish tenant finishes, moving and telephone expense allowances, increased or free parking spaces, lease buy-outs, personal perks for top management, or health club memberships.

The lease may also include adjusting the base year for the purpose of pass-through of increased expenses, release of hazardous waste liability, an option to renew at the same rental rate, and an option to cancel at no penalty.

Beware of the pitfall encountered by over-anxious owners who are pressured into assigning too much parking to gain a tenant. Later they often find that the balance of the building's space cannot be leased because of inadequate parking. If parking is assigned, abide by the parking rate established. If not assigned, parking can be over-subscribed based on an acceptable ratio.

Increasing the tenant's finish allowance can work as a benefit for both the tenant and the owner. Showing upgraded finished space is a good marketing tool during re-leasing and enhances the value of the building. Conversely, the use of expensive finishes can greatly increase the future cost if reconfigured.

Usually an owner determines an acceptable minimum rentable rate--that is, a quoted "street rate," less a maximum dollar amount allowable for concessions. This permits the concession package to be structured to fit a prospective tenant's needs.

The "costing out" of concessions before they are offered or accepted is critical to the building's fiscal stability. Using the "time value of money" concept to calculate the effect of concessions in arriving at an effective rental rate not only reduces the incentives to today's dollars, but also provides a comparable comparison when evaluating the competition's proposals.

For example, assume that the rent is $20 per square foot; that the lease term is 10 years, with free rent for 24 months; and that the discount rate is 10 percent. The time value of money would be calculated as $20 for each of eight years, or $160, divided by the length of the lease. The effective rate is $16 per square foot.

Conclusion

It is essential that owners and property managers recognize the true conditions affecting the real estate market in their areas. Agreement needs to be reached concerning a long-term strategy based on economic and local market research to be carried out through a carefully prepared plan.

Use every resource available, including advice from counterparts who have successfully managed under similar conditions. Develop a local and national network for problem-solving.

Just remember, the property manager who can survive in a soft economy and an overbuilt real estate market can succeed in any market!

The author wishes to thank the following contributors to this article:

Steven M. Wennerstrom, CPM, president and principal of Vantex Realty Services, Inc., Denver, a full-service commercial real estate firm specializing in leasing, brokerage, property management, and construction management.

Bodie Beard, CPM, president of Bodie Beard Interests, Inc., Houston, a firm specializing in commercial appraisal, review, and analysis.

James Aamot, CPM, principal of JCA Property Management, Denver, a property management and leasing firm specializing in office buildings.

Julia A Banks, CPM |R~, is principal of Banks and Company, a Denver firm specializing in the management and leasing of apartments, office buildings, and business parks. A member of IREM's national faculty, she has also served as a IREM regional vice president. She is an adjunct professor for the University of Denver and also instructs for the University of Colorado, Division of Continuing Education.
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Title Annotation:real estate business in Houson, TX, and Denver, CO
Author:Banks, Julia A.
Publication:Journal of Property Management
Article Type:Industry Overview
Date:May 1, 1993
Words:3961
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