The impact of the Covid pandemic on real estate can be compared to a severe draught. Just as few life forms can survive on earth without water, so too is the impact of a cash flow draught on the health of capital investment in real estate. Cash flow is water to invested capital,which is the life form of real estate. Like all life forms, if deprived of water, is unsustainable.
In times of severe draught, farmers and ranchers for centuries have learned that it is better to ration the water and save the strong than to try to save the entire crop or herd. They know the rains will come again and enable growth to come back stronger than before.
Capital invested in commercial real estate is no different. Covid has severely limited cash flow across several sectors. Thankfully, not all were affected the same. Some, like the desert plants (industrial) will even thrive as changing consumer habits significantly accelerate the demand for modern logistics facilities. Even this sector will see weakness, especially in the smaller manufacturing and service sectors.
The smart capital has already started culling their herd. Starwood letting go of $1.6 Billion invested in six malls is a good example. It's not that the real estate is fundamentally bad, although malls are disproportionally impacted, it's more a case that the entire capital stack, both equity and debt is severely compromised. The only logical play is to preserve equity for other stronger opportunities. They even made a play to buy back the properties but were outbid by more aggressive capital.
This is just the beginning. A high rise office building brought to market at the beginning of this year in a second tier but growing market expected to achieve pricing that would cover the debt (which was coming due) and preferred equity position with a little left over for the sponsor. The impact of Covid compromised the quality of the exiting rents as well as future lease up, hence obscuring near term income visibility, and exacerbated the capital expense underwriting required to make the building competitive with modern product in a post Covid world. The result was a drop in value by over 20%. The lender just took over the asset and will have to sell it soon because it is not in the business of deploying the requisite equity capital to resuscitate the property.
Smart money invested in office, retail, hospitality and some multi-family (CBD luxury and workforce), are reviewing their entire portfolios with the mindset of equity preservation. Sometimes the correct strategy can be counter intuitive. It might make sense to sell quality, which is high demand, to feed growth opportunities. In other cases, it might make sense to walk away, like Starwood did, or the owners of the office building mentioned above, to preserve equity for future growth investments. The important lesson is to conduct a review of the entire equity portfolio, whether it's one property or a hundred.
Over the next 12 - 24 months, we will see the smartest money moving fastest to preserve equity and be prepared to invest in new opportunities as they arise. Time is the enemy. We just completed a strategic portfolio optimization plan for a client showing them how to increase the value of one component by 50% (hundred of millions of dollars). In the wake of the GFC we helped owners and lenders save hundreds of millions with repurposing properties and executing capital markets strategies. The key is being proactive and dispassionate. Cull the heard. Preserve cash flow for growth.
Equity needs to be watered to bear fruit.