Triage in Commercial Real Estate Operations

This February marks my seventh year as a capital allocator in commercial real estate. Much is routine. Yet, I still find myself surprised by unexpected challenges.

As my portfolio has grown, the scale and scope of problems have increased. I would have expected this increase the be proportionate, but I'm not sure that's true. It seems to me from my experiences that the complexity involved in managing problems accelerates as portfolio value grows. That is, the relationship between asset value and complexity is exponential rather than linear.

I believe the following contributes to what I've observed.

Scarcity In Capital

The first contributing factor is scarcity. The resources you have at your disposal to manage any problem are fundamentally limited. We build reserves and plan for setbacks. However, there's a point with too many concurrent problems where resources become exhausted.

Scarcity is a problem at all levels of investment. A small asset faces similar limitations to those of a larger asset. But scarcity is less visible, and perhaps less impactful, in practice for small assets because the quantities we're dealing with in absolute terms are also small. This seems obvious, but the implications are significant.

Consider the following example. An owner of a two-million-dollar asset replaces an HVAC unit for $10,000. This isn't an insignificant repair by any means. Someone who is financially capable of acquiring two million dollar's worth of commercial real estate isn't likely to balk at the $10,000 sum. This is just part of the game.

Now consider a marginally larger investor, a sponsor with limited partners, encounters an issue with the cooling loop for her ten million dollar asset. The repairs in this case will requires outlay of $100,000. Currently, there are allocated reserves available to cover 50% of the job estimate. Now finding herself undercapitalized, the sponsor will need to issue a capital call to fund the repair project and replenish reserves.

In absolute terms, the second project is 10x the first. But on a relative basis, the first repair represented 5% of asset value whereas the second repair only 1%.

One consideration: sticker shock is a real thing. Problems that are smaller in magnitude but still material in relative terms seem to be manageable. In the second example, while a repair of 1% is unlikely to derail an investment's performance, the capital call will constitute a mark against the sponsor's record. Simply, the bigger the number the scarier it is regardless of materiality.

Another consideration: the capital structure becomes increasingly rigid as dollar value rises. The small investor is able to cover expenses first-person (which may lead to lower discipline, but that's another topic). The modestly larger sponsor encounters a problem reserves are unable to cover and leans on their small LP pool to fund the issue. Not a pleasant undertaking, but these are related parties you have relationships with, so feasibility is high and cooperation is expected. 

Now swing to the other side of the spectrum. The largest sponsors will likely not share the same support from their investor relationships as the small sponsor. They may have to access public markets; a slow process. Meanwhile they have a problem to address but accessing liquidity will take time. 

The moral, anticipate a decline in financial flexibility as amounts increase in absolute value regardless of materiality on a relative basis. Instead of operations become easier with growth, we'll instead prefer to be more defensive as dollar value rises and optionality falls.

Personnel

Your team can only battle so many fires at once. It's nice to believe that issues will be responded to and mitigated as they arise. But, that's not reality. We build teams to a certain scale for capacity to handle a reasonable load, and perhaps then some. Though, there will always exist some threshold where your team's ability to respond to problems is exhausted. We can't build teams to handle every possible situation since this would be prohibitively costly.

What happens when teams are stretched thin? Absent planning or managerial intervention, I'd expect my team to react to problems chronologically: first in, first out. I don't think it's unreasonable to follow this approach. Chronologically managing problems is logical. Doing so removes discretion so the employee faces less direct risk. It would be challenging to fire someone for dealing with issues in the order the issues originated.

If the team member isn't incentivized or motivated to accept personal risk, then it would be irrational for them to deviate from a chronological approach. But now let's assume the employee is sufficiently driven, and perhaps invested or just risk seeking, to deviate from chronology. In this set up, what is the result? If we're still operating in a framework lacking a triage structure, the scariest stuff may be what's reprioritized away from the original sequence.

Reorganizing your response to deal with the largest, most pressing problems may be an improvement from a chronological approach. There's wisdom in not rearranging deck chairs while the Titanic is sinking. Relatedly, if you're fixing a lightbulb while standing in water, it's possible your priorities are misaligned and dealing with your biggest problems first could be a better approach.

But also, perhaps not. Dealing with the largest problems first and doing so without structure may be an emotional response. Such a response is more pathos than logos which can result in inconsistencies. We don't want personnel reacting emotionally. Emotional responses don't scale, are difficult to review post facto, and lead to irrational and impulsive actions. Don't underestimate your ability to make things worse. 

The most critical point against emotional responses, my scariest problems are not always the most important. Image two situations with two assets. Building A has gone completely dark for an unknown reason. Services are offline building-wide. Building B has problems of its own but that's limited to a single Water Source Heat Pump (WSHP) that's affecting a single suite. One problem is clearly larger than the other.

Now imagine, Building A is vacant while Building B is occupied, the suite affected has a medical tenant, and the outside temperature is significant. Building A may have the larger  problem but the effect isn't being proportionately felt, if at all. Building B has a relatively minor problem but the effect may be much larger in magnitude. Disruption in services may be a big deal to this tenant. A delayed response may mean you need to adjust your re-leasing assumptions downward as goodwill is destroyed.

Information Transmission

Information in real estate can move slowly. Real estate is a slow-moving industry in general. That said, I've found that bad information flows slowest.

Within any hierarchy, each level receives the information and assumably makes some sort of decision or takes some sort of action before either resolving the problem or passing it upward to the next level of the hierarchy. The more tiers in the structure, the slower information will flow.

When the news is bad, there's going to be motivation for an employee at a given level to solve the problem. On one hand, everyone has an obligation to determine whether a problem is solvable within their respective domain before escalating, otherwise leadership will be overburdened. This is a central purpose to chain of command. On the other hand, an employee may be relatively averse to transmitting negative information relative to positive information.

Negative information could be perceived by the employee to be detrimental to their career if they're worried they may be tied to the bad news. There may be an intrinsic management principle here.

How you handle negative information will affect how much information you receive and how quickly you receive it. You don't want your reports to become gun-shy. When gathering information on a difficult topic I try to calm and objective, even avoiding questioning that could imply the employee's responsibility unless my concern is negligence on their part or some degree of culpability that can't otherwise be ignored. Else, this isn't the time for employee review. Doing so isn't going to improve the ability for the employee to be effective in their role at a time when you may need to rely on them most.

Approach

So how to I manage my portfolio when everything is going wrong, resources and personnel are stretched? I try to balance a handful of competing factors:

• First in, first out;
• Greatest-to-least in magnitude;
• Greatest-to-least in affecting future revenue;
• Most to least in recurrence; and
• Grouping.

First In, First Out

Every problem needs to be dealt with eventually. Allowing problems to persist will erode tenants' and others' confidence in your operations. Delaying a response to an issue indefinitely isn't a viable (and may eventually constitute breach or cause other legal problems).

Because of this, I start my triage with chronological order. If resources are sufficient and my team's bandwidth isn't exceeded, this approach is alone is all that's needed. When resources and/or personnel are no longer able to deal with problems as they arise, I introduce additional dimensions to the decision-making process.

Greatest-To-Least in Magnitude

Now let's assume I have two problems differing in magnitude but similar in all other qualities. In this case, my preference will be to manage the larger problem when compared to the smaller problem. But why?

I assume that there is an implicit, additional cost that a problem accumulates the longer the problem remains outstanding. This cost can manifest itself in a number of different ways. An example would be a water leak. The longer the problem remains, the greater the extent of the problem. The issue doesn't remain static from the point of recognition, but will worsen with time.

A leak is a simplified example, but this 'rent,' if you will, can manifest in less obvious ways. Large problems often affect secondary or downstream systems. Weather barriers are good examples of this. The scope of your repair my begin as a roof repair. However, if this isn't dealt with quick enough, interior components will be affected.

Regardless of how secondary degradation and cost manifests through time, I expect the cost to be somewhat proportionate to the scale of the originally identified problem. Therefore, I should prefer dealing problems greater in magnitude sooner than lesser problems, holding other factors constant.

Greatest-To-Least in Affect On Future Revenue

This ties in to the former consideration but relates more to the non-physical costs of a problem. The idea is that it's possible to have problems that are relatively minor in scope and scale but can have a material and disproportionate effect on future revenue.

Consider a scenario with two repairs at a property.

A water leak occurs on the high floor of a multi-level property occurs causing significant damage to drywall and other interior surfaces. Much needs to be demolished and rebuilt. At the same time, minor damage occurred to the wall of the same building's lobby. A moving company has damaged the lobby's wall and left a somewhat noticeable gash needing repair. The lobby repair is an afterthought operationally. It's not anticipated to be any significant cost financially or in time.

Using the previously mentioned factors to triage these problems would likely lead you to believe the high-floor repair, larger in scope and scale, is the more emergent repair. And fair enough, we shouldn't wait around long to work on this. That said, only the tenants on the high floor will be affected by the water damage repairs (assuming the problem remains isolated). Meanwhile, everyone in the building, including those on the high floor, will walk past the scuff in lobby and may determine that we're unresponsive, incompetent operators even though we're working tirelessly to mitigate the bigger problem first.

Certain issues can be symbolic. There may be less patience awarded to you for issues in the lobby compared to the high floor problem. These are problems I would want addressed concurrently in the least.

Furthermore and as a side note, don't underestimate how much positive goodwill can be generated by being responsive to small, inexpensive items but that are highly visible. There's wisdom in picking the low-hanging fruit first.

Most-To-Least In Recurrence

The revelations I've had surrounding this particular topic have been particularly impact on my management philosophy and career.

Let's assume that a certain problem is met with a competent approach in mitigation, the effort and allocation was sufficient to put the problem to bed, and a team reasonably believes the problem was indeed fully mitigated. What happens when the same problem, or one similar recurs?

I've found recurrent issues to be particularly challenging for a couple of different reasons.

The most obvious concern with a persistent issue is that future revenue will suffer as a result of your customers losing confidence in your product or service. On the customer/tenant side, there's only so many times you can complain about an issue until you've had enough and changes will be made. This should be obvious.

What I found particularly profound was the impact recurrent problems have had on my team. When the similar issues happen again and again, a fatigue grows with each occurrence. The marginal event demands a greater emotional and mental load on the person managing the event.

I would go so far as to say a fear or anxiety begins to develop of, "Will I be able to solve the problem this time?" Now we're thinking emotionally and we can expect our decisions and actions to be negatively affected. Because of this, it's important to recognize recurrent problems early and prioritize their resolution for your team's sake. Confidence is quicker to destroy than build. And confident decisions and actions are efficient. We should desire this from our team.

Last, it may be useful to point out the nuances of problems to your team facing recurrent issues. Certain problems can appear quite similar superficially but may be a diverse problem with low correlation to the preceding event. Reminding an employee they're facing a different issue may help to preserve their confidence in themselves which in turn will help to keep your operation running efficiently. 

Grouping

Grouping in managing problems is something I would consider least impactful in my decision making but still present in this process and certainly relevant. Problems similar in scope should be managed as a group.

Those in leadership may possess a natural tendency to group projects in an attempt to minimize costs associated with task-switching. But this may not be as obvious for employees with smaller domains. The default in this case may be back to chronology and it could be helpful to remind your employees that tasks are most efficient when grouped by nature.

Although switching is costly from a time-to-completion perspective, there are explicit costs that can be avoided. Similar issues being managed on different days using the same personnel generate costs in preparation, inefficient sourcing of materials by purchasing in smaller quantities, time lost in transit, etc.

I try to encourage problems to be grouped when doing so doesn't compromise the objectives of the previously mentioned constraints and considerations

Final Thoughts

The common theme here is optimization. When I encounter problems, especially when in both complexity and volume, my thought process is centered around optimization: How can the identified issues be mitigated with the fewest resources? I use the mentioned framework for making this determination. 

Also, this isn't something that's simply been internalized; a set of principles that passively affect how I make decisions. I try to deliberately run through the mentioned factors as a component to my triage process. I find that doing so reduces errors and preserves objectivity as much as possible. It also reduces stress in that you're able to trust problems are being competently mitigated even when your senses are telling you that everything is burning. These are the times that measured, unemotional decision making demonstrates an operator's value.

Last, I want to make an observation.

I'm no Blackstone. My portfolio is quite small relative to larger players. However, I suspect that there may be diseconomies of scale in commercial real estate. The items mentioned above speak to operations becoming less manageable with scale. On the other side of the spectrum, smaller operators with smaller assets may have an operational advantage. Theirs assets are less complex to administer, information flows to decision makers quicker, and scarcity is less of a concern. I suspect these factors and other may allow small operations to deliver a superior product for less cost and risk.

That, combined with natural heterogeneity of commercial real estate, may suggest that commercial real estate is best operated by small-to-medium sized portfolios. Some scale is beneficial, but there comes a point where scale begins to commoditize the product. The best commercial real estate experiences I've encountered have been created by competent, passionate, and well-funded small operators; let's say portfolios less than a billion in asset value.

That said, it's not likely you're in business to remain small. As you grow, consider what's mentioned above to manage complex issues in the face of scarcity.