Preserving Cash in Commercial Real Estate

For What Reason

If we do our job correctly as asset managers, we should enter a project with defensive strategies, scenario analysis and stress tests, reserve funds, and so forth. However, planning for the downside requires that we have an understanding for what challenges we're going to encounter. This isn't always the case. In January of 2020, it was difficult anticipate the scale of the lockdowns and disruptions that followed a couple months later in March due to the Covid-19 pandemic response. Sometimes, we're going to encounter difficulty that wasn't foreseeable. We need to have an idea, or better a framework, for how we're going to respond to adversity.

Where Problems Originate

Downside risk can originate from anywhere. The 'left tail' is a tricky part of the probability distribution to navigate. That said, many of the problems I've encountered can be grouped as follows:

Exogenous Factors

This includes economic shocks, disruptions from pandemics, war, etc. While quite broad in comparison to the categories that follow, exogenous factors can often be felt approaching. In January of 2020, we didn't yet know how governments would respond to the pandemic. But we did see headlines of a growing contagion as early as December 2019. When events are in motion that have the potential to cause us damage, we need to adjust to a more defensive posture until it's becoming clear the danger is passing. Specifically, I try to answer the following questions to guide my response:

• How will the threat affect me if it is realized?
• When will I know if the threat is real and whether I'm likely to be affected?
• What measures can I take today to increase my defensive posture while not overreacting and derailing my investment objects for a threat that isn't a certainty?
• Have my new concerns been properly communicated to relevant parties?
• What will my second-level response be if I am affected?
• When will I know if the threat has passed and I should relax my defensive posture?

Physical or Environmental Problems

Threats to the investment from issues with the structure or the land it sits on can be devastating when mistakes are made. While investors are somewhat forgiving of underperformance relating to exogenous factors, I've found investors or substantially less forgiving of issues such as those they might perceive as avoidable. We can't inspect every component to a structure, but at the end of the day, it was your selection as asset manager and your reputation is on the line.  

For this reason, I'm especially risk averse to physical or environmental threats. Targets with elevated risks to these threats should be viewed with greater scrutiny and be passed over quickly, if necessary. Proximal to gas stations or other in-ground chemicals storage? Not interested. Even when the threat is identifiable and you believe your planned mitigation isn't cost-prohibitive, remember that your assessment may likely understate the scale and scope of the problem. Add a very large margin of error if you're going to proceed. A well-structured purchase agreement will have strong seller protections for these specific issues so once on the deal, recourse options are limited.

Tenant Defaults

Much of what you're paying for on a leased-up project is rent roll. Leasing costs are substantial so there's a premium paid for in-place cash flow. For this reason, our lease review analysis is thorough to better understand the quality of what it is we're purchasing. However, the best credit models are simply not predictive for the size of our rent roll's sample relative to the leasing market. We use renewal and default assumptions with our acquisition models, sure. But this is for lack of a suitable alternative. I'm consistently surprised by what tenants fail or move. 

What is the statistical significance of default and renewal probabilities used industry wide? I wouldn't be surprised to learn these practices carry little informative value. And if they possess any value at all, the cost exceeds the benefit. Nonetheless, we'll continue to run these analyses for defensive, record keeping reasons if nothing else. Somethings are meant to demonstrate the thoughtfulness of the approach for purposes of signaling.

What I've found most affective to mitigate tenant risks is to increase engagement with tenants. There can be a stigma the relationship between landlord and tenant is adversarial. I find this to be a factor in tenants acting aggressively from the onset where such behavior wasn't necessary and potentially counterproductive. However, tenants and landlords sit on the same side of the table. Our destinies are inextricably connected. Engage early and often with your tenants and there's the potential that you may learn of problems brewing. Perhaps there's even the possibility of offering assistance. 

When Things Get Bad

If you're in any business long enough, you will experience hard times. As an asset manager, I'd rather be judged by my performance during turbulent markets than rising markets. In commercial real estate, we have many threats to deal with when things get bad, as discussed earlier. However, for those who survive and those who are lost, it comes down to one thing: cash. The following consists of a couple of my approaches to cash preservation.

Suspend Capital Projects

An obvious solution, perhaps. You can't concurrently undertake capital projects while implementing cash preservation initiatives. But there's a handful of traps we as asset managers fall into with capital projects. The biggest mistake I consistently encounter: "The cash is already allocated to a separate bucket." Cash is cash. I don't care what the intention you’ve communicated to your investors at the onset, cash spends the same no matter the source. Cash should be reallocated for defensive purposes until the threat passes. If the threat never materializes, continue along with your improvements. Along these lines, make sure you're giving yourself flexibility to reallocate cash to respond to threats by your governing documents.

The next mistake I see, possibly more often: managers becoming emotionally anchored to capital projects. Timelines are often long; capital project planning is often years in the making. Moreover, capital projects often reflect/incorporate the personalities of the managers. Parting with a project can be emotionally challenging. However, it's on an order of magnitude easier to communicate a change in plan than it is to deliver a capital call to your investors. Bad news that requires your investors to write a check is the worst kind of bad news we can deliver.

Re-Evaluate Services

Routine services should be evaluated from time to time to determine if optimal. In practice, does this always happen? Perhaps not as often as we'd like. So, take this opportunity to evaluate if there are lower-cost vendors that can offer a similar level of service or services that can be eliminated altogether. Be careful not to cut a service that your leases to oblige you to provide. You should also be careful not to signal trouble to your tenants or other observers. The elimination of services my demonstrate financial woes. Cutting services may also harm your renewal probability and give the appearance of being a cheap landlord. A reputation that can hinder future leasing prospects.

Efficiency Projects

If you're able to entirely pay for an expenditure in the current period through gains in efficiency, you have a paid-for project. This category of protecting cash is one of my favorite methods of generating savings. It's not without its risks. If you're wrong about how much you'll save relative to how much the expenditure will cost, then you're worse off than before you started. For that reason, you need a high degree of confidence in your undertaking. For evaluating these projects, I try to use internal data as much as possible. The industries supporting efficiency related projects are filled with knaves. 

Another reason I like efficiency projects is that, unlike cutting services mentioned before, you're spending money and improving your structure. Often, spending money on improving your property conveys a positive message to your current tenants and prospective tenants. This can have a positive impact on your leasing operations as your asset appears more attractive. Of the efficiency projects at your disposal, my preferred is LED lighting. Often, there are utility rebate programs to partially offset project cost and lighting is one of the best ways to improve the appearance of a space. There are second-order benefits as well. Conversion from incandescent to LED lighting will reduce the heat output of your lighting infrastructure. This decreases the load on your HVAC system or a second-order cost savings.

What Not to Do

To preserve cash, spending less seems straight forward. However, postponing or canceling certain projects can hurt your cash even further. We need cash flow to sustain our operations. Cutbacks that threaten future cash flow should be avoided wherever possible. For example, projects preparing suites for leasing or that otherwise maintain the attractiveness and competitiveness of your asset need to be continued. Postponing investment necessary for cash flow generation will deteriorate your troubles further. 

Conclusion

Threats to your operations can pop up anywhere and at any time. While we should always take care in managing risk, inevitably the unexpected will occur, and we'll be forced to respond or fail. Whether the threats be exogenous, asset, or tenant related, have an idea of how these threats can be detected and dealt with. Take the time to consider what options are available to you when times become difficult as times inevitably will. Inaction is often harmful but don't discount your ability to make things worse. Have a plan.