Winter is Coming to Commercial Real Estate

A commercial real estate developer shares his insights on how to prepare for it.

By John E. McNellis, Principal at McNellis Partners, for The Registry:

On Friday, the S&P 500 was down 2.8% for the year. Like a dead rat in the basement, everyone can smell the next recession, everyone knows it’s coming, but no one knows when. Nobody. The clever pundits give its commencement the same wide berth they would accord that moldering rat.

One acquaintance, however, rushed in where economists fear to tread and called it, proclaiming March 2020 as the next recession’s kick-off. He could be right. Having predicted five of the last three recessions, I have no idea but, at the risk of putting mittens on at the outset of Indian summer, it may be useful to consider how a real estate professional might survive a financial winter.

Suggestion #1: Keep your job.

As truisms go, “now is always the right time to get into real estate” isn’t bad, it has a nice ring to it, it even makes some sense, but there are better and worse times to ditch your day job for the joys of working without a net. Today is one of those worse times.

With the economy having baked longer than one of my mother’s unfortunate Christmas turkeys, the percentage play would be to keep your paycheck over the next several years. The time to BASE jump is at the depth of the recession—when you’re closer to the ground—not the week before it starts.

Suggestion #2: Sell.

Whether you own a single duplex or a portfolio you take your shoes off to count, ask yourself a simple question: Should I sell before the snow flies? Benjamin Franklin observed, “There are three faithful friends—an old wife, an old dog and ready money.”

It takes decades to earn an old wife, but you can achieve ready money with one quick sale.

What should you sell? Your sitting ducks: your projects leased at top-of-market rents, those rented to marginal tenants and those most susceptible to future competition (i.e. located where land is cheap and zoning codes are broken as often as the 10 Commandments). And your over-leveraged properties. What happens to your project if commercial values plunge 20%  or more (they tanked 40% in the Great Recession) and you need to refinance in the next five years? Would you have any equity left? Would you be able to refinance at all?

To this point, we have sold five small, single-tenant properties thus far this year, are in escrow to sell two more and are dickering with a potential buyer on an eighth. We had no need to sell any of these properties; rather, we thought it was a good time to harvest profits and deploy the cash elsewhere. Against this wave of selling, we traded several of these properties into one much larger asset, a well-located, supermarket-anchored shopping center.

Suggestion #3: Pay down debt and finance long.

How did we use the cash that didn’t go into the trade? Simple. We paid down debt and, in one case, bought out an equity partner. Our company goal has always been to carry as little debt as possible at a fixed interest rate with the longest term we can obtain.

Yes, this strategy is too conservative in good times and acts like a drag chute on new deals. And, yes, you can feel dumb when everyone else is doing five deals to your one, but you will feel much smarter, if not to say downright smug, when the recession deep-freezes the markets and your bankers will still buy you lunch.

These suggestions are easy enough to swallow: Staying put is a piece of cake, selling can be fun, and repaying debt is kind of like going to Sunday mass: It can be a little painful, but you feel better afterwards. Harder to accept is this:

Suggestion #4: Drop marginal projects.

If you’re not already under construction, reevaluate your project and ask yourself whether it still makes sense. If your numbers now look skinny, sell it or mothball it. Newton’s first law of motion (objects in motion tend to stay in motion) has claimed many victims; you have no wish to be one. Also known as inertia, this law is a major factor in the high rate of divorce—the bride figured out her fiancé was a bum long before the rehearsal dinner, but her family had already sent out the invitations and rented the hall.

Inertia also drives a world of bad deals. You’re half way through your permitting process when you notice the first frost on your pro forma—leasing has slowed, lenders are edgy and contractors insouciant—but you push on with lower pre-leasing and perhaps a second-tier, more expensive lender. And then, if you somehow missed the news beforehand, you discover just how much construction costs have soared in the last couple years. Yet you persist, marching down the aisle, telling yourself the project’s financials will look better on completion. They won’t.

One major apartment builder in Northern California told me yesterday that construction costs here are rising 1% a month (yes, 12% a year) and that if you factor in the rental concessions his company is now giving away, they are not meeting their targeted returns on investment. He also said that some smaller developers are already giving up the ghost on their new apartment projects, irretrievably buried beneath the preferred returns due their financial partners, unable ever to make a personal profit on their developments.

The strategies that work so well in a bull market can take you down in a recession. When it freezes, animals adapt. Bears hibernate, birds fly south and bees live off their summer honey. Time to start thinking about adapting. By John E. McNellis, author of Making It in Real Estate: Starting Out as a Developer.This article was first published on The Registry
 

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  40 comments for “Winter is Coming to Commercial Real Estate

  1. Petunia
    Dec 14, 2018 at 4:14 pm

    I managed to finish my Xmas shopping without setting foot in a retail store during the entire month of Dec. Black Friday weekend was the first and last time I was out Xmas shopping in a store. If I’m any kind of indicator, you are on the right track with your commercial investments. Food and the hair and nail salon are the only things that drive me to a store these days.

    • William Smith
      Dec 14, 2018 at 5:41 pm

      Those nail polish drying lamps can cause cancer under the fingernails, google it. And some of those new nail polishes are [chinese] toxic (especially the fumes). If it comes from china (as most stuff does) it probably is laced with unregulated heavy metals and/or industrial chemicals. Please be careful what you put in & on your body, regardless of the current commercial real estate financial conditions.

      • Petunia
        Dec 14, 2018 at 6:46 pm

        Considering the state of the entire country, the dangers of a nail salon are the last thing to worry about. Besides, ever since they stopped animal testing of beauty products everything is irritating and/or toxic.

    • Javert Chip
      Dec 14, 2018 at 6:16 pm

      Got ya beat: I’m bald, cut my own nails and my only time in a brick-and-mortar store was Sears, but you’d be proud of me:

      I needed a vacuum (I buy a new one every 15 years, just like clockwork). Found the model I wanted on the Kenmore site for $349 (plus tax=$372); priced on Amazon at $269 (plus tax=$286); a Sears brick&mortar sold it to me for $208 (tax inc).

      The most amazing thing was discovering a Sears store actually had what I wanted; total time in store (which looked, smelled, and felt like a morgue) less than 15 minutes).

      • Petunia
        Dec 14, 2018 at 6:48 pm

        When your vacuum breaks, and I fear it may be sooner than you think, buy a Shark, the kind from the infomercials on tv, mine is great.

        • Javert Chip
          Dec 14, 2018 at 7:11 pm

          Note to self: Shark.

        • Insta
          Dec 15, 2018 at 8:46 am

          Second Petunia on the Shark. My wife has tried others that didn’t work as well or broke down and now that she has a Shark it is her favorite she has ever had and won’t go to anything else. She has the Shark Rotator.

        • Dave
          Dec 15, 2018 at 12:20 pm

          Do the Sharks eat up the dirt?

        • Petunia
          Dec 15, 2018 at 12:34 pm

          Dave,

          Yes, great vacuum and well priced. Like it a lot better than my old Electrolux or Hoover.

  2. 2banana
    Dec 14, 2018 at 5:44 pm

    After much thought and research I have come up with a partial solution to what is coming. Feel free to add.

    1. Take care of your health.  Exercise.
    2. Stay out of debt. Live beneath your means.
    3. Keep learning. Learn new skills. Learn how to fix and build things yourself. Invest in yourself.
    4. Realize that government (at all levels) will lie to you. Government will not take care of you. Government will take everything you have if it means they stay in power just one day longer.
    5. Buy a little gold and silver. Bitcoin if you must. But realize that this is just a little insurance and not much else.
    6. Stay far away from bubbles. Hard to do when friends and relatives are getting “rich” and think you the fool
    7. Relationships are worth far more than “stuff.” Families are worth way more than “stuff.”
    8. Enjoy life. It doesn’t take lots of money.
    9. Learn how to shoot safely and have at least one gun. Even if you never touch it again.
    10. Be part of “something” bigger than yourself such as a Church or a volunteer organization that actually helps people. All the issues we see today are the same issues seen 2000 years ago.

    • Mike R.
      Dec 14, 2018 at 5:52 pm

      Good stuff!

      America will reset. We will go back to solid values.

      It will be a very painful, even violent adjustment.

      Humans are basically stupid when it comes to important stuff.

      • Richard
        Dec 15, 2018 at 3:48 pm

        Mike R.
        I agree. There is a major “reset” coming, and while I have some ideas what it may look like, won’t really know until we get there.
        The global balance sheet is way out of whack, and can’t be resolved without major writedowns or write offs. Organic top line revenue growth is also insufficient to satisfy debt servicing costs.
        Hold on tight, it will be a scary ride.

      • JZ
        Dec 16, 2018 at 6:36 pm

        Come on, you have to go out and take on debt and consume! If you don’t, “THEY” will trash currency, raise prices, reward anybody who takes more risk and more willing to be debt slaves than you are. They will have bigger houses, more attractive spouses, flying in private jets while you try to stash worthless currencies, gunn powders and cherish your little freedom that you are NOT obligated to anybody.
        Your freedom will collapse before all the beautiful houses, lavish lifestyles brought by the mighty debt. This is the land of debt and consumption. You are in the wrong country if your value is being free and brave. This is the land of wealth transfer from the free and brave into the hands of the debt loaded consumpyors. If you resist, you will be punished by the all mighty FED and US Treasury.

    • AV8R
      Dec 14, 2018 at 7:00 pm

      Three.

      And 10, but I was a Marine. Its hard to explain.

      Just. Do. It.

    • nicko2
      Dec 15, 2018 at 5:23 am

      America sure sounds like a scary place. Forget the guns and gold, improve yourself, network, relocate to a city investing in the new economy (and a state with a sane view of social services – ie. Well funded education and health). The future is being built in the world’s cities.

      Getting out of debt is still the best advice.

    • RepubAnon
      Dec 15, 2018 at 7:59 am

      If you buy a firearm, stay in practice and keep up your skills – and keep the weapon maintained. It’s like a car: having a car in the garage for years without driving it or maintaining it is a bad idea: even if the car starts, you’ll probably have an accident when you try to drive it.

    • Paulo
      Dec 15, 2018 at 1:49 pm

      Excellent list.

      Instead of # 5 I keep cash on hand, tools, stores, firearms, etc and all kinds of ‘camping’ gear. etc etc etc

      All of this stuff works well for any disaster. Here, we have planned for a subduction zone quake which helps peace of mind. I even have a good ham radio set up for emergency comms.

      Big storm should hit us in about 4-5 hours. We will lose power, but for how long it is impossible to determine. My wife and I don’t miss a beat. In fact, I probably won’t even drag the generator out as we have batts, LED lighting, etc always ready to use.

      New arrivals here sometimes don’t even have candles, or a working flashlight. Heat? They huddle at home shivering unless they stay somewhere else. They go to a restaurant for their meals (the restaurant has a gennie and freezers). :-)

      Gotta be a good scout as this unfolds. Be prepared. Say no to DEBT!

      • Squirrel
        Dec 17, 2018 at 8:38 pm

        Disasters are merely an inconvenience, for those that prepare for them.

    • And
      Dec 15, 2018 at 4:51 pm

      I like it- reasonable things to live by.

  3. Maximus Minimus
    Dec 14, 2018 at 6:00 pm

    Suggestion #5: Don’t fight the FED.
    When the FED supports the drunkards, the gamblers, and other trash of humanity, the smart choice is to join.

  4. Tom Stone
    Dec 14, 2018 at 9:17 pm

    Simple, good advice that few will follow.
    As I drive around Sonoma County ( Especially Rohnert Park and Santa Rosa)
    it’s easy to discern which of the developments won’t make it.
    I expect to see “Prices slashed” on a lot of the homes now under construction by June 2019, the “Free” upgrades and double the usual commission to independent Realtors (Not salaried employees of the developers) only works until the appraisals stop hitting the number.

  5. raxadian
    Dec 14, 2018 at 9:27 pm

    The word pundit comes from India and means learned person or sage there. In the US it means paid mouthpiece.

    Malls are sitting ducks, supermarkets are doing okay, so I guess it averages out?

    • Dec 15, 2018 at 1:37 am

      raxadian,

      Explain your implications before I take it the wrong way (in which case you’ll have to find another site to post your comments).

      • raxadian
        Dec 16, 2018 at 12:50 am

        What I meant was that people you tend to see on TV or hear on radio promoting something are usually paid to do so. That’s it.

        Malls are huge, take a lot of money to build and only do okay when the economy is booming due to them selling somewhat expensive goods.

        Supermarkets tend to sell food and somewhat cheap stuff so they have more clients.

        Malls are hard to turn into something else. Supermarkets can be converted into a different business more easily.

        That doesn’t mean a supermarket is a good investment, location and prices are a thing to worry about, more so during an economic crisis. And more so when supermarkets are on a price and or discount war with each other.

        A good location might mean people might be willing to pay more because they save on gas while a bad location means that even with lower prices people might not be wiling to go there because is too far away.

        Not to mention supermarkets tend to sell perishable goods, so not having enough sales means the products just expire without selling them.

        And of course there is online sales.

        People nowadays is willing to buy food and clothes online. Produce is different because people wants to see (and touch it if they can) before buying.

    • QQQBall
      Dec 15, 2018 at 12:13 pm

      Radian,

      Supermarkets. I went in a Vons yesterday for the first time in ages. They have a lot of multiple item pricing schemes; you have to buy 3 or 5 of a item to get a better price. I was must struck by price increases beyond the now typical downsizing of packages. The garbage “ice cream” was more expensive than I remember and the packages have shrunk.. I did note that the sale items shelves were nearly bare and the in-house cookies were now like 7 bucks where they were almost always $5 Friday item. One thing I had not noticed – they sell 1/2 pies – I think it was $5.99 or $6.99 for 1/2 a pie in a special 1/2-pie container. I looked at that 1/2 pie and thought about the wealth distribution here. That 1/2 pie says it all – you can still eat cake/pie, but only 1/2 as much as before for appx the same price as a prior whole pie.

      • Petunia
        Dec 15, 2018 at 2:46 pm

        Food is so expensive our favorite bakery now sells cakes by the slice. A whole cake can cost as much as $35. The rent must be too damn high.

        • raxadian
          Dec 16, 2018 at 12:55 pm

          Cafes have been selling cakes by the slice for almost a century, but yeah is probably the rent.

          When I look at those prices I almost want to bake a cake by myself and then I remember the time I gained a ton of weight because I baked a cake every week…

  6. Paulo
    Dec 14, 2018 at 10:48 pm

    Re: “Our company goal has always been to carry as little debt as possible at a fixed interest rate with the longest term we can obtain.”

    Good for you. What a refreshing attitude. My son and I were discussing a local developer the other day. The developer builds all across Canada, in every location imaginable. He has unbelieveable numbers of people working for him and many many dedicated contractors. I tried to explain to son that when a company is that big, its debt is unbelievable and has reached a point of money in and money out counted by accountants and controllers. Also, there was really no way for any outsider to understand what was going on, or of it was all a deck of cards?

    I once worked for a contractor who everyone said owned all the bells and whistles. One day he was caught flying 1500 lbs of high grade BC bud in his floatplane. They arrested him at his dock in front of his lake front home.

    Debt makes people do strange things. It’s called survival.

  7. Stephen Sadd
    Dec 15, 2018 at 1:12 am

    Wolf, this may interest your readers, leave it with you! Thank you for 2018 financial happenings etc, its been an interesting year, and it is people like yourself that gives us hope!
    Thanks!

  8. Sporkfed
    Dec 15, 2018 at 2:44 am

    Oddly enough, in my small city we are getting 2 more grocery stores
    in addition to the 5 we already have, and have more bank branches
    than I’ve seen anywhere else. Something has got to give.

  9. carla
    Dec 15, 2018 at 9:02 am

    No price graph, no volume charts, nothing?
    I agree that the market is stretched thin. But I don’t see the big price cuts yet.
    Some people are so leveraged that, as usual, they will go under at the slightest tremor. Then it cascades down to stronger hands, and finally hits support when the strongest investors find value.
    It’s always the same cycle.
    That feedback loop works the same on the banking side, where everything is peachy from rosy “appraisals” at the top and going aggressive on personal guarantees (” we had to have the owner file for personal B, there was no other options, says the bankers with humid eyes”) at the bottom.
    We ain’t there yet.
    I’m sitting on a few mil to deploy when that happens.
    As usual.

    • Bill
      Dec 15, 2018 at 12:31 pm

      It’ll become more apparent as “ask” prices float to aspirational levels scaring away even the most bullish investors.. leading to price cuts that only reduce the “ask” to the insane prices from only 12months ago.

      And when rates climb further That is the point where everything goes in reverse and the house of cards tumbles. Not to zero, just down enough to make the game attractive again. Some areas that will only be 20%, in less desirable areas 60%.

      Commecial retail is a tough one. I live in Oakland, Ca and I see more empty retail than occupied. There’s only so many nail salons and hair salons a community can support. Food businesses struggle in any economy.

      My idea is to convert retail storefronts to residential, for badly needed housing. That would take some rezoning.

    • Paulo
      Dec 15, 2018 at 2:02 pm

      MIL Military
      MIL Mother-In-Law
      MIL One Thousandth of An Inch
      MIL Million
      MIL Matrox Imaging Library
      MIL Malfunction Indicator Light

      So, you can use your malfunction indicator light to warn the Military to go sit on your mother in law until she moves one thousandth of an inch towards the Matrox Imaging Library where AI will tell you, “Quick, grab your MIL and buy some RE.” Holy smokes, that one acronym has everything covered. Looks like you’re ready. :-)

  10. Pl’n’l
    Dec 15, 2018 at 11:13 am

    Construction and Real Estate. The two are synonymous with the terms Feast or Famine. Though developing business and trade expertise is important to succeed, the thing most vital to success in the long run is learning how to play the cycles. The most important lesson learned in my 43 years as a contractor.

  11. Kenny Logoffs
    Dec 15, 2018 at 12:58 pm

    1% a month is 12.68% a year.

    Just sayin.

  12. Chris from Dallas
    Dec 17, 2018 at 1:12 am

    With multiple assets, we are leveraging up some as high as possible and paying off others and paying off all personal debt.

    In a downturn, lenders can’t foreclose on the paid off assets, can’t take our homestead here in Texas no matter the value, and will be more willing to adjust terms to kick the can down the road with the highly leveraged properties.

    Free and clear properties can then be leveraged up even in a downturn, but of course at a lower value and lower loan-to-value ratio.

    As an example, assume you have 3 houses worth $100,000 each with $50,000 mtgs. It is MUCH BETTER to leverage 2 up to 75% LTV and pay off the 3rd. Total LTV stays the same at a relatively low 50%.

    Even better, they are now offering FIXED 30 year financing to investors instead of 15 year floating (for those of us with more than 4 properties).

    …Yet another sign of crazy lending and forthcoming doom…

    However, depending on the rate and remaining term of existing debt, the increase to a 30 year term can increase cash flow by 40%+… which is a great way to protect against the downturn.

    Plus, if the SHTF and values drop 50% and LTVs drop to 60% like in the Great Recession you can still get $30k cash out of the free and clear property.

    Multiply these #s by values in your area and greater quantities of properties and the resulting amounts can get very large.

  13. Chris from Dallas
    Dec 17, 2018 at 1:14 am

    P.S. winter is coming to ALL real estate, commercial is just first in line. Time to stock up on necessities and batten down the hatches.

  14. Eureka
    Dec 19, 2018 at 11:31 am

    Read the book sale of a lifetime. Good insights

  15. Dec 19, 2018 at 11:00 pm

    I have a question for Wolf: Is there any site that gives stats on commercial real estate capacity and utilization? I assume it would be a good economic indicator.

    • Dec 20, 2018 at 2:32 am

      CRE on a national basis is complex because it includes multifamily, offices, industrial, malls, strip malls, student housing, etc, all with their own dynamics.

      For example, I have access to local office market data of this type (vacancy rates, etc.) but these are good only for measures of the local market. And they say nothing about the national market. Houston, for example, still has a office market disaster on its hands, and I covered it a couple of times, but in other cities, the office market is tight and hot.

      Occasionally, I cover a national CRE price index (Green Street).

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