The Slow and Painful Recovery: Is This What Change Looks Like?

(This is a reprint of an article written for Wrightwood Capital.  Click here for print version

It’s difficult to remain up-beat in times of crisis, recession and recovery.  The economy is improving, but it doesn’t always feel good. At the same time, there are plenty of reasons to be positive. Commercial real estate transactions picked up in the fourth quarter of 2010 and everyone seems to be very busy as we start a new year. Investment and credit conditions have supported the raising of values off the bottom and lenders are beginning to clean out their portfolios in earnest. According to Real Capital Analytics, recovery rates on defaulted loans had risen on average to 68% at the end of 2010 while the more conservative defaulted loans held by insurance companies were experiencing upwards of 80% recovery rates. At the same time, U.S. property sales are on the up-swing, with over $134 billion of sales in 2010 and an upward trend that promises even more in 2011.

But rental rates have yet to improve, and tenant demand, outside of multi-family, has been anemic – leading to national vacancy rates ranging from 15% to 22% for office and rental growth in the negative numbers all over. Depending on where you are, rents have fallen by as much as 40%. Many in our industry have faced the most difficult two years of their professional careers. There are signs of light ahead, but we aren’t out of the storm yet. There will likely be more challenges for us all to face. As Charlie Wurtzebach, Professor of DePaul University’s Real Estate Department, has put it, “Right now, we’re all feeling less pain than we felt in 2009, but we’re still in pain. This is only a lessoning of the pain, not an elimination of it.”

Despite the pain, Bruce Cohen, CEO of Wrightwood Capital often speaks to a different viewpoint, “The pain we’ve all gone through has been more about change than collapse. Part of why our organization has long assumed things wouldn’t be as bad as many projected is because of people’s ability to adapt and respond to changing circumstances.  Instead of just observing the current state of things simply extrapolating it out, it’s important to consider changes that always intervene – good and bad.  This market is adapting to a new dynamic and responding accordingly.”

There’s little doubt that the economy as well as commercial property markets are going through a process of meaningful change. Whether it’s a deleveraging and re-pricing process, or a rethinking of tenant demand, this is a time when it is difficult to predict what will happen month-to-month, and every successful investor, financier or operator must be able to change assumptions, processes and expectations. 

Bruce has not been alone in this outlook. I recently sat down with a friend of Wrightwood Capital, and recent participant in the 4th Quarter 2010 RoundtableMartin Nesbitt, to get his take on how he thinks this recovery will play out. He is the CEO of The Parking Spot which he started in 1998 to provide a unique approach to airport parking that adds an uncommon level of service to off-site airport parking and shuttles. Anyone who has travelled by air in the U.S. in the last 10 years is likely to have seen their bold yellow and black polka dotted shuttles bringing travelers to their gates from 19 different parking lots across the country. When Martin participated in Wrightwood Capital’s fourth quarter 2010 roundtable, he brought a decidedly positive perspective on the recovery now in process.

Airport parking can be used as a leading indicator of business confidence and investment as its volume of business is determined, to a great extent, by the amount of business travel taking place. According to Martin, “October 2010 was the highest revenue month in the history of our company. Business people are leaving their offices, getting out there, doing their jobs and getting new business. I may be the leading edge of the recovery, so I’m seeing the bounce before a lot of others. We are almost back to 2007 numbers.”

When Martin reflects on the current state of the economy, his view is positive – but, just like Charlie Wurtzebach, not without caveat, “I don’t expect a huge spike during this recovery or dramatic level of growth, but it is going to be a steady grind of continued improvement. What I am optimistic about – and many other people are beginning to have faith and confidence in – is the fundamental resilience of our economy. Despite some very real challenges, there is a strong foundation that holds it together. We’re starting to see the benefits of that, with unemployment beginning to decline and most businesses beginning the process of adding jobs. My guess is that unemployment will be below 9% before the spring – maybe even significantly below that.” According to the Bureau of Labor Statistics February 4, 2011 jobs report, unemployment is already at 9%. However, with only 36,000 jobs created in January 2011, there will have to be quite a bit of new hiring to reduce unemployment further.

More than the strength of our banking system or the wisdom of any monetary policy, Martin identifies one attribute as a driver of global competitiveness and the eventual return to full economic robustness: “Ourcapacity for change is one of the reasons we lead the world. We have the largest population of entrepreneurial and creative risk takers in the world. Our diversity and creativity, combined with a system of government designed for constant change is what makes this country work. That change may not always be pretty. There’s dislocation of businesses and people. There is, at times, tremendous gridlock and frustration. But fundamentally, our government listens to its people – and is willing and able to make change. At the same time, business is learning how the market is changing and is figuring out new ways to succeed given the new landscape. Our capacity to respond, change and be competitive is our long-term competitive advantage.”

According to Martin, the companies whose cultures are most attuned to change will be able to take full advantage of the recovery. “Historically, there are a lot of successful and strong businesses that failed because the marketplace changed around them but they didn’t change to adapt. As an investor, entrepreneur or executive, it’s important to institutionalize a capacity to change and adapt. You can’t just revisit your strategy every 10 years; there has to be a culture where the need for change is considered every single day. It’s an important part of leadership and important part of how you build a successful institution that survives over time. You need to build a culture of perpetual change. Every once in a while there is an inflection point, like now, when change becomes very visible. When it works at a high level, where it is more painful and more obvious.”

It is difficult to deny that both politically and economically we are living in a time of very visible and often painful change. Our government is going through a messy process of sorting itself out at the same time that our economy and the commercial real estate industry is stumbling it’s way back to recovery. Martin’s point, and one to keep in mind, is that no matter how messy that process of change might be, it is essential. Our willingness to engage with that change will determine our future success. “It is the way that successful investors need to think: constantly modify and adapt strategies all the time. Things are definitely getting better, there are new opportunities emerging everywhere, but there’s a lot of change left to play out. The economy is on a rebound because we are able to change, adapt and create value in new ways.”

That seems to be happening in commercial real estate. According to Bruce, “Wrightwood Capital’s upbeat point of view has long been influenced by discussions with Martin and others and on what they are seeing in their businesses. Now we have a new lower basis for acquisitions.  Thanks to the measured and careful process of extending and modifying debt, the market wasn’t flooded with unreasonable discounting in 2009 and 2010. Instead, with values rising somewhat, it’s possible for more ordered disposition to take place. New investors are able to then adjust rental rates and return expectations to the new reality of the market.  The market knows how to change.”

The recovery is slow, painful, and even messy. This is what change looks like.

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