It is often said that volatility breeds opportunity. True—but only for those prepared to jump in and weather the storm until there is a fair share of attractive opportunities to be found.
In today’s uncertain financial environment, industry leaders are actively retooling business strategies, rebalancing capital structures, devising proactive solutions to issues, and ultimately positioning themselves for success throughout these unpredictable markets. In short, top-tier owners are not stumbling upon prosperity; they are proactively developing well-vetted strategies designed to take advantage of dislocation in the market.
Developing those strategies involves seven often overlooked, but crucial, components.
Learn from the recession, revisit business models, and make adjustments.
While most business owners like to believe they have established the ultimate business model, true entrepreneurs realize that strategies and objectives must be constantly revisited. In times of distress, devise methods of expansion to complement the current business strategy.
Is now the time to become vertically integrated and create internal property management? Is now the time to raise a dedicated investment fund to capitalize on fast-moving distressed transactions? Perhaps a recycling of assets by selling nonstrategic locations and redeploying the capital into the company’s core markets is a more strategic alternative. Measure the success of competitors and do not dismiss their performance as a fluke, but embrace the reasons for their success.
Re-underwrite legacy assets as new investments.
In the four years or more since investors acquired their legacy portfolios at peak market pricing, the real estate landscape has changed dramatically. The assets have suffered years of wear and tear, the once-predictable demand drivers have changed, new supply never contemplated has appeared, the once-bullish capital markets are far less exuberant, and many aspects of the real estate business have changed. Apropos to this new economic reality, it is imperative to disregard the past, and honestly evaluate and re-underwrite existing investments and create new, realistic business plans that take into account the availability and cost of today’s capital, the financial and other resources required to execute business plans, the appropriateness of future growth assumptions, the viability of local economies, competition in the market, and other customary underwriting criteria. At stake are not only the risks of further impairment to asset value, but also the appropriate allocation of financial and human resources.
At the core of a reassessment is determination of whether the potential returns associated with legacy assets exceed the potential of new investments available in the market today. In analyzing the hold-versus-sell decision, it is best to view the net proceeds that a sale of the legacy asset today would generate as an entirely new investment. One then must consider what level of cash flow the legacy asset can realistically produce over the next three years, including residual proceeds. If this cash flow yields an internal rate of return on the new investment that does not meet or exceed returns that are otherwise available in the market generally, it is better to dispose of the legacy asset and reinvest the proceeds or—at the very least—allow investors to redeploy the capital. At times, some owners are tempted to simply hold their assets, thereby avoiding reality and escaping the need to realize losses in the short term.
Should it be determined that holding an investment is appropriate, take advantage of inexpensive and underemployed construction trades to upgrade properties to better compete against overleveraged and cash-strapped competitors, who will be at a distinct disadvantage. Upgrading will allow the property to achieve higher occupancies and superior rents as well as attract better-quality tenants.
Evaluate management teams and interview competitive management companies.
Far too frequently we accept the fate of an underperforming asset because we repeatedly receive the diagnosis from the same “doctor.” During periods of subpar operations, diligent owners should orchestrate management company interviews and solicit proposals for improving operations. While a management change may not be able to correct fundamental property and economic issues, a fresh perspective may revitalize efforts and bring valuable new insight, tenant relationships and leads, and cost savings arising from recently reduced management fees and/or collective purchasing contracts.
If new management is being considered, one must take into account the inevitable decline in performance during transition periods, the startup costs associated with new management, and possible property personnel defections. If a change is still warranted, it is important to replace management on a timely basis, well in advance of crucial periods or events.
Review the viability of property capitalizations for longer hold periods.
Now is not the time to devise business plans reliant on shoestring budgets over multiple years in the face of looming loan maturities and backed by cash-strapped and distracted equity partners. Owners should reduce leverage on legacy assets when possible, take the time to educate lenders well in advance about challenges, suggest realistic solutions, identify potential equity partners to replace debt with new equity, and secure bids for new loans. Often the underwriting from a new lender in connection with a refinancing will help an existing lender understand the current unbiased perception of property values and issues, which may in turn facilitate a more favorable restructuring or potentially a discounted payoff of the loan.
There is no better time than now to refinance property debt to benefit from low interest rates, use apprehension about capital markets to negotiate discounted loan payoffs, and/or shift debt exposure to more flexible balance-sheet lenders. Do not wait to assess capital structures; match maturities with the duration of the business plans and deleverage when possible. Hoping for improved performance to refinance is just that—a hope, not a plan.
Build and maintain investor and lender relationships.
Most lenders and institutional equity investors have recently shortened their lists of desired borrowers and partners and are much more stringent when embarking on new relationships. This insular approach compels owners to establish lender and investor relationships well in advance of anticipated refinancings or last-minute opportunistic investments. Many distressed sellers today value a reliable buyer and a timely closing more than other aspects of a transaction, including price. If a buyer is not aligned with a reputable capital source, the bid may be largely ignored by the seller. Similarly, a lender willing to allow a borrower to repay its debt at a discount will be reluctant to issue a term sheet or proposal until the borrower has identified its capital partners to facilitate the transaction.
Do not forget about new deals.
Time-consuming asset management of legacy assets is often the culprit causing an empty deal pipeline. While an unflagging commitment to avoid a loss is important, owners should confer with lenders and investors before expending substantial asset management resources. Many prefer the realization of a partial loss, as long as it is coupled with a current distribution that provides an opportunity to redeploy capital into higher-yielding new investments or use the money for much-needed internal purposes.
When confronted with the choice of unspent new capital or a well-managed but low-yielding legacy portfolio, savvy investors most certainly would prefer owners to focus on the forward pipeline of new investments. Nothing disappoints investors more than uninvested capital during productive cycles, and nothing leaves an owner more frustrated and financially strained than overly burdensome asset management costs to produce marginal yields.
Employ investment strategies built to better withstand headwinds.
If the recession taught owners anything, it is that markets do not progress in an easily digested, linear fashion. To fortify a pro forma projection, employ acquisition and development strategies using substantially more equity, structure debt maturities of at least three years, underwrite local economies and not just properties, avoid precarious assets that are solely reliant on tenuous job growth, and identify more liquid asset types and markets with clear interest from both lenders and institutional owners.
