S.E.C. Real Estate Observer

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Newton’s First Law is often summarized as An object in a state of rest or uniform motion will remain in that state unless an external force is applied. For every action there is a reaction. Have we been in this Goldilocks economy for so long that we have forgotten this law? Interest rates are low.

What external forces can be applied to CRE? The list has no end, but some of the common ones are interest rates, CAP rates, lack of mortgage funds, obsolete uses and/or business models, and outside forces such as war, weather, and other force majeure.

Objects in motion tend to stay in motion in a straight line unless acted upon by an outside force. The inertia of our industry has been straight up for so long that we must be reminded not to fall asleep at the wheel, miss the curve, and run off into the ditch of a changing environment.

The SEC has some outstanding new Counselors who have become Members over the last several years. Some remember 2008, but many were not around in 1980, especially in Texas, Louisiana, and Oklahoma. Some have lost some money, but most did not lose their shirts. It is like comparing my experience in Vietnam to World War II. Yes, we went through some tough times, but there is really no comparison to what the WWII soldiers went through.

So what could we forget? Interest rates come to mind. I have spent a lot of time thinking about what the 10-year Treasury bill might look like over the next 12–24 months. We try not to do thin deals, so if interest rates go up 100 basis points, it won’t be preferable, but our deals can still work. We can even stand 200 basis point increases in our permanent financing. But we have to keep in mind the inertia of what that means. If interest rates go up, CAP rates probably follow. If the CAP rate goes up, the appraised value goes down. Do you have enough equity in the deal that you can meet your lender’s loan-to-value and/or the debt coverage ratio if we experience a 200 basis point increase in the Treasury and you get a vacancy? We were doing 75% loan-to-value deals until recently. Now I am basing our developments on 70% loans and will reduce that even further if we get larger increases in the 10-year Treasury.

I preach “covered debt.” I do not like personal liability debt, but I use it to increase the return on capital. I have been able to get banks, typically joint and several lenders that want 100% personal liability on the debt, to agree to several, not joint and several, terms. And my first question in interviewing a new lender is, “Do you see the lack of contingent liability on my balance sheet?” I ask them up front if they are impressed with the total asset values and the low contingent liability. They always respond “yes.” Then I tell them how I plan to keep it that way. My typical remark is that if they do not think the asset is worth something, they should not make the loan. Therefore, we start out down the path with less than 100% personal liability.

We ask whether our investors can lose 100% of their capital in the deal without changing their lifestyle. As sponsors, shouldn’t we ask ourselves the same question? Cover the debt!

One thing that is certainly having an effect on our real estate is the evolution of retail. I have said many times that retail is not dead; it is just evolving. We see that every day. But what are the effects on industrial because of the changes in retail? I had not even considered the “last mile” industrial concept ten years ago. I guarantee you that it is high on my mind now. I cannot believe that I can’t buy packages of red and green felt-tipped pens at Staples (they now come in mixed packages of several colors, some of which I do not use), but I can get them the next day in boxes of single colors cheaper than buying what I do not want at Staples. I may not want to build the 500,000–2 million sq. ft. last mile warehouse at a 2% spread on a 5% CAP, but I might want to service the suppliers and maintenance people who service them. We need to know what is going on up the food chain.

The same thing is going on with single-family residential, multi-family, hotels, medical offices, and all other types of real estate. The internet has having material influence like we were told it would. Changing demographics is having its effect also.

I do not worry about force majeure. There is no doubt that even the best weathermen and women can’t forecast the weather correctly every time. War is constant, and trying to plan around it is impossible. My time is spent trying to predict things that I can react to or plan for. That is our obligation to our families and partners.  For every action . . .