Future Proof Your Future: Considerations & Strategies in a Transforming Market
As your trusted advisor in the commercial real estate industry, I aim to provide you with the insight and guidance to help you navigate the ever-changing market landscape. Here I delve into four crucial categories that demand your attention as business-owners and investors in the Southern California market: the ongoing bank crisis, maturing loans, unique challenges in this next cycle and creative strategies to mitigate risk and preserve value.
From 2012 through the middle of 2022, we had the most one-sided market anyone in our industry has ever seen. Repeated government intervention extended a 7-year market cycle to 12 years and it now appears time for the market to cleanse itself. For those who missed last summer’s peak and plan to wait for the next one to take action, it’s worth noting that it took 10 years to peak again after the bottom of the last cycle. Even if you have that kind of time, the trend line is not going to be “up and to the right” and will likely be more volatile than past cycles. There are numerous external forces property owners need to confront that they have not had to in previous cycles. These include behavioral shifts, negative population growth, artificial intelligence, reshoring of supply chains and dramatically higher operating costs to the tune of 15-25% YOY, in some cases.
The banking crisis is far from over and will take some time to fully play itself out. Community and regional banks are in the crosshairs, and it just so happens they are also the life blood of CRE lending, making up approximately 70% of loan originations. The lending environment has become increasingly tight and will remain that way for some time. If you have a loan coming due, I suggest you start ASAP exploring alternative sources of capital. On the other hand, reduced access to credit for potential buyers and investors makes selling your property more difficult with a dramatically limited pool of qualified buyers.
Over the next 24 months, there are trillions of dollars in loans maturing. These loans either need to be paid off or refinanced at rates 300-400 basis points higher. This trend will undoubtedly impact asset prices across all property types and necessitate forced price discovery. Large office towers will likely be the catalyst and one that cannot be isolated. Empty office properties negatively impact the revenues of restaurants and retail services that surround them. As forced price discovery plays out, we need to think about the 2nd and 3rd order effects such as erosion of the tax base. How will cities and counties respond when their tax revenues are cut in half? I don’t think we really anticipated or fully modeled out what that could look like and how that impacts other city services we all use. Take San Francisco for example—as of today, the city is on track to lose about $80 million in tax receipts a year. If real estate starts trading at scale at 50 cents on the dollar, it’s going to be way worse than that. This is not specific to San Francisco. In the last 90 days both Orange and Los Angeles Counties have recorded large asset sales at 50-60% discounts. This is not likely to be a singular event, but more of a slow process that plays out over the next 24-60 months, impacting various submarkets and property types at different times. This is where the new, higher quality assets will separate themselves from the pack as they maintain value while older properties fall out of favor, suffering price declines and smaller pools of potential buyers and tenants.
In investing, the notion that “this time is different” has ended many careers. Before you tell me to hit the showers, hear me out, as I believe this next cycle is going to be unlike any other because we must confront external forces that we have never seen or experienced in our lifetimes.
1.) Behavioral shifts and changing consumer behavior are transforming the ways businesses are operated and ultimately, valued. Certain businesses will no longer be viable acquisition targets.
2.) Negative population growth in California will impact demand and values for commercial real estate.
3.) Artificial intelligence will disrupt everything as we know it. While this presents exciting opportunities, it also poses challenges in terms of workforce needs and space utilization. Being mindful of these advancements will be crucial.
4.) Significantly higher operating costs to the tune of 15-25% YOY. Rising labor and energy costs, coupled with burdensome regulatory compliance, will impact profitability. Developing an effective cost management strategy will be imperative to maintaining a competitive edge.
I am a glass-half-full kind of guy, so by nature I like to look at this doomsday scenario as an opportunity. If you are asking yourself, how do I turn this into an opportunity?Step 1 is to get informed, and I would argue you are well on your way since you made it this far into my letter. Step 2 is proper planning. $7 trillion of Baby Boomer businesses will be sold by 2030.Almost all of them have a real estate component to them and those who own their real estate are likely sitting on a 2x-4x return. Proper planning enables you to maximize the value of each asset. In certain situations, the business and the real estate need to be a single package, but the majority are two separate transactions over multiple years. The “cleansing” of the market combined with the challenges I mention above open up opportunities for creative deal structures we have not seen (or used) in many years. Start thinking outside the box with solutions such as a sale-leaseback, installment sale, charitable remainder trust and utilizing private lenders.
Sale-leasebacks offer a stable, long-term solution to restructuring your debt now that the lending window for refinancing has been slammed shut. If you have retirement in your sights, sell the real estate now and sign a lease that coincides with your retirement timeline.
Installment sales, also known as seller financing, are a great diversification play for any portfolio. You can exit the real estate, lower your risk profile, pay your taxes over time and create an income stream for your retirement years. Not to mention, it feels good to “be the bank” for a change!
Charitable Remainder Trusts allow you to receive lifetime tax-free income, satisfaction of one’s philanthropic goals and also qualifies you for a charitable income tax deduction.
Private lending is not the same as “hard money”. These are private individuals or funds that are filling the hole left by traditional banks. They are providing capital at market terms to businesses and investors that make our economy so resilient and enable our communities to thrive in good times and persevere through hard times.
In the next edition, I am going to introduce a theory known as the Exponential Age. It is centered around six innovative technologies all hitting escape velocity simultaneously. How will our businesses, economy and investments fair as we approach this critical juncture? I have some ideas but I’m not entirely certain. I do know that for all three, time can be your greatest ally or your biggest enemy. The best way to navigate these uncharted waters is by staying informed and proactive. Together, we can adapt, think outside the box and turn these challenges into opportunities for growth and success.
For the sake of brevity, I only scratched the surface on each of these topics and I’m more than happy to dive deeper if you would like to continue the conversation. Thank you for your continued trust and confidence in my perspective and expertise. I am here to support you every step of the way.