Over the last few months, news channels have been filled with stories about movements that are directly affecting the U.S. economy and real estate investments. Headlines discussing rising interest rates, the government shutdown and trade wars dominated the airways and have increased business uncertainty. In addition, the speed of advancing technology is continually shifting the commercial real estate landscape. Shopping centers are clearing out at record rates as major retailers that had been a staple in the economy for years declare bankruptcy. There's one thing most everyone can agree on: The real estate industry has become the poster child for uncertainty and anxiety.
With significant change in commercial real estate circles, skillful real estate managers need to learn how to pivot swiftly or face the risk of being left behind. Below are three ways commercial real estate organizations should adjust to stay relevant.
1. Fill the space.
Real estate investment companies should reconsider their existing tenant mix. Long gone are the days of 10- to 15-year leases. With any uncertainty in the business market, corporations are often looking for a short-term lease. As the tenant strives to become more nimble by limiting their growth and/or downsizing risks, real estate investors should consider altering their antiquated long-term business models. While short-term leases may alter financial forecasting and real estate valuation, immediate increases in net operating income will outweigh the risk of carrying the vacant space.
Conversely, offering free space can end up being a valuable alternative when diversifying the tenant mixes and increase the overall experience of the property. For example, some mall owners are giving their empty space to co-working companies, startup restaurants or incubators in order to attract other tenants into the complex. Although these example tenants don’t pay rent, in exchange for a relatively small space they can increase the property's visibility, foot traffic and overall interconnectivity. That, in turn, makes properties more desirable.
To prepare for this new normal, investment companies can increase their leasing capabilities, partner with co-working operators or upgrade their digital strategy to attract these new-age tenants.
2. Build relationships.
In times of uncertainty, two things are needed most: growth capital and support from peers and partners. The best strategy any real estate investor can utilize to ensure future stability is relationship building. While the industry is in the growth cycle, capital is bountiful. However, as soon as the cycle turns, having capital is the difference between muddling through and controlling destiny.
Understanding and growing capital relationships comes in two forms: existing capital sources and new prospects with unrelated capital allocations. When it comes to the existing capital relationships, real estate operators need to stay in touch, constantly, while the market grows. As economic cycles change, so do banking relationships. During the current cycle many banks have merged, disappeared or changed their primary business line. Investment managers must remain in tune with the direction banks are headed while working toward anticipating the impact on business.
For example, banks that focus on real estate lending might concentrate on commercial and industrial loans after a merger which, in turn, might diminish the negotiating power of borrowers in a downturn. In addition to current capital providers, real estate managers should focus on acquiring alternative sources of equity and debt. A multitenant office owner might want to seek a partnership with a single, long-term tenant equity provider in order to mitigate the risk of short-term leases. Alternatively, office asset managers might want to connect with industrial capital sources in order to diversify high-cost risks, like retenanting office buildings. This leads us to the next topic of diversification.
3. Diversify your assets.
As previous down cycles have shown, not all property sector markets are affected equally by the downturn. While the rise or fall of employment numbers might affect the office market, industrial markets could thrive due to the increase in e-commerce.
During the last cycle, we noticed that manufactured housing and self-storage sectors fared better than other property types. According to Trepp Bank Research's April 2017 report of historical CRE losses, self-storage had the lowest average loan loss severity of all property sectors at 1.52%, while manufacturing housing loss was at 3.53%. Comparatively, in a different sector, retail had an average loss rate of 6.17% and office at 6.13%. While taking into consideration these examples, property sectors (per research completed by Nareit in December 2018) and manufactured homes provided total returns of 24.93% and 11.43% for the years 2017 and 2018, respectively.
Diversifying into alternate property sectors can help spread risk across your business. However, with any business decision, real estate managers need to be prudent in evaluating their decisions. While diversification can provide a footing to weather storms, businesses must be prudent as diversification efforts have their own risks. To successfully evaluate business decisions, investors need to consider a few key questions during the entire due diligence process: What oversights can be pulled from current practices? Who are the allies in this diversification process? For example, a hotel manager might bring their niche of customer experience into focus when running an office building.
To stay relevant, future real estate leaders need to continue on the path of innovation. While transformation is tough, the only way to continue growing is to advance with the times. As it was in previous cycles, great things come to those who are able to pivot during the hardest times.
