The commercial real estate industry is known for its cyclical and unpredictable nature, but events over the past several years led by the pandemic and its lingering impact, the work from home phenomenon, the shifting of office space from the urban to suburban environments, and the unprecedented swiftness of rising interest rates have generated an overall feeling of anxiety. What is the best course of action to best navigate the downturn? Weighing in with perspectives from personal experiences are Scott Dorsey, Chairman and CEO, Merritt Properties; Nancy Ferrell, Executive Vice President, Northmarq and Gary Gill, Chairman & CEO, MacKenzie Ventures.
Local market remaining relatively strong
Scott Dorsey (SD): “We are not yet seeing a downturn in the local market, but that may change depending on what happens with the Fed and China over the next year. Our leasing people are as busy as they have ever been with more than 80 new industrial and office leases signed this year alone. We see completely different dynamics in our light industrial and suburban office portfolios, however, and have very little light industrial space available. There is almost no opportunity to build new product. We have been working to obtain permits for our redevelopment of the former GM plant in White Marsh since early 2021 and are now just starting construction. Office is a different challenge as Covid has changed the way people view their office needs. We would rather have 40 smaller tenants in a particular building, than four larger ones, because that reduces our overall risk.”
Gary Gill (GG): “Not everything is perfect, of course, but our overall vacancy rate across the board remains very good. Our buildings are like having a bunch of kids — they all have different personalities and their ups and downs — but things usually work out in the end. The worst time in my career was the late 1980s, when the economy was extremely bad, banks were taking back buildings left and right, interest rates were high, and the Fed overreacted with some of its policies. If you were an active developer during those times, you were getting whiplashed from all sides and things were extremely scary.”
Nancy Ferrell (NF): “Each cyclical downturn is a bit different in causation including the over-supply of product, economic recession, lack of liquidity or a combination thereof. Rapidly rising interest rates have created a big disconnect in valuation between sellers and buyers, resulting in very little acquisition activity over the past year. Similarly, these rates have caused owners to reevaluate any plans to refinance to capture trapped equity. Risk is again being priced into investment decisions and higher benchmark rates of return will require higher rates of return from CRE investments.”
SD: “The problem in the late 80s and early 90s was not that the economy was so bad but, rather, the bank regulators destroyed the real estate industry and eroded values with some of the policies enacted. That is what is making me nervous now. I recently read about groups of Wall Street folks who are pulling together funds in anticipation of acquiring distressed real estate. Interest rates may seem high now, but for most of the last 50 years, we have been dealing with interest rates of 9% or higher. For the last 10 years, rates were 3% — less than in the Eisenhower era. In the last year, or so, the cost of capital has nearly doubled and that is a serious concern, particularly with regards to refinancing.”
GG: “I saw that article, Scott, and it gave me chilling flashbacks from troubling times as well as a reminder to always be prepared for fluctuations in our industry. There are times when interest rates make us look smarter than we might be and, in the past several years, with rates as attractive as we have ever seen, we refinanced about 90 percent of our projects. That provided us with the safety valve of having fresh 10-year terms, with few loans maturing in the next 7 years that would face current underwriting.
NF: “Market participants learned from mistakes following the S&L crisis and CRE depression of the early 90s to not hit the panic button and liquidate their positions. Instead, stay the course and have faith that we will all get through this downturn like we have with others. Save some of your money when times are good since you may need that cash to help survive downturns. Choppy and declining markets require more effort and more frequent communication to successfully navigate.”
Lean on your relationships
SD: “In the late 80s and 90s, many banks financed land and subsequently foreclosed when values eroded. Certain parcels of land — formerly worth $300,000 an acre — were available for $50,000. Many people predicted building fire sales during the pandemic, but that never really materialized. There is an old saying: if you owe $1 million to a bank, the financial institution owns you. If you owe $100 million, you own the bank. That is of course tongue-in-cheek but a reminder of the importance of having great relationships.”
GG: “Forty years ago, personal guarantees on loans were the norm, and there were times when we felt we could go down the tubes, but we survived and were stronger because of the experience. We learned that, when in doubt, it makes more sense to borrow from local and regional banks which are relationship driven. Now, 95 percent of our loans are with those financial institutions. That has value in choppy waters.”
NF: “We are seeing contrarian investors taking a hard look at office, but the debt capital to purchase assets is limited and investors need significantly more cash in the deals. Office building to multifamily and mixed-use conversions have been underway for some time, but the current downturn may accelerate future projects. Yield requirements are moving higher and those who can transact now will find better risk adjusted returns provided they can make the capital stack work.”
Advice to Developing Leaders
SD: “We often receive notes from our tenants thanking us for doing a great job … usually for simply doing what we said we would do. We stress that to our employees — do what you say you will do, be committed to the team and everyone will benefit from the company’s success.
GG: “One of our company mantras is SUAHWAGA which means ‘Show Up And Hustle With A Great Attitude.’ It is important for young professionals to learn about everything in the industry and become engaged in both the industry and the community. If your work is not fun, it is just work, but working at what you love to do is fun.”
NF: “It is essential to visit the office every day, rather than working remotely, and find a strong mentor who is invested in your future. You can learn more discussing deals over lunch with your peers than you can over a Zoom call.”