“You must never confuse faith that you will prevail in the end — which you can never afford to lose — with the discipline to confront the most brutal facts of your current reality, whatever they might be.”
Survival is always the first order of business. This is just as true in business, more specifically, commercial real estate, as it is in nature. In his seminal book, Good to Great, Jim Collins includes an episode about the Stockdale Paradox; which Robert Glazer brought up again in his Friday Forward missive last Friday. The story is about how the highest-ranking POW in the Vietnam War, Jim Stockdale, survived over 7 years of torture at the Hanoi Hilton. The concept is not new. It is said that King Solomon’s ring was inscribed with three Hebrew letters on the gold band: gimel, zayin, yud which began the words, “Gam zeh ya’avor” - “ This too shall pass”. We see it again in the Bible, Corinthians 4: 17-18. It was also said to be one of Abraham Lincoln’s favorite sayings.
So how does the Stockdale Paradox Impact Alpha for property owners and lenders? The ugly truth, which must be confronted, is that the unintended consequences of government intervention due to the Covid -19 pandemic destroyed supply chains around the world while creating unprecedented demand by printing and distributing trillions of dollars. Exacerbated by an untimely war in Ukraine and new technology enabling people to live, work, play and buy stuff wherever and whenever they want, these actions have created massive inflation, which has pushed operational costs of owning real estate dramatically higher, while redefining the purposefulness of “space” as “experience”. This inflation pressure on costs, coupled with an evaporation of demand for generic office space, has set the stage for massive value destruction in Class B and C, and even Class A office. Class B & C office has been reduced to land value as the cost of delivering an “experience” is too prohibitive. Pressure on rents has driven Class A (“experiential space”) down by 30-40% and in some cases 30% of replacement cost. Industrial buildings are worth more than Class A office in many markets.
For those of you who have been around since the early 1980’s this is your 5th rodeo. In every single case, the survivors all saw that the only way to survive was to confront the ugly truth and walk through the fire repeating the mantra, “this too shall pass”. This was never truer than in the few years after the GFC. Many investors thought the world was coming to an end. The S&P bottomed on 3/9/2009 at 666. It’s now at 3,670 at EOB 10/13/22. We will all get through this, but some will get through it better than others. As described in the Stockdale Paradox, it will not be the optimists. They are the ones who never make it through. It’s the realists who survive. They are the ones who recognize the ugly truth about their situation and implement a plan to help them survive. The optimist hangs on hoping for a quick rebound (freedom) in office space demand. The realist acknowledges that the value destruction has only just begun (this situation could last a long time) and has an action plan to protect and preserve their equity and survive this perilous financial storm so they can thrive in the aftermath.
What does that action plan look like? It’s very simple. In an era of accelerating asset deflation, the best strategy is to eliminate the corrosive effects of debt and monetize equity positions to allow for re-entry at a lower basis. Why feed the debt beast when the basis is 40% - 50% above market and the debt is correspondingly, 40% too high? The most at risk and controlling equity positions would best Impact Alpha by monetizing selective equity positions and redeploying the capital where there is better upside. That could be other properties with a lower basis or even into REITs which have very strong balance sheets but whose stock prices have been beaten up by fear. Uncertainty in the capital markets has paralyzed allocators from making long bets without very high-risk premiums built into their models. Right now, fear is winning, but greed usually wins in the end. This uncertainty and fear have created a risk arbitrage opportunity to acquire properties with yield premiums that are 30%- 40% higher than just 6 to 9 months ago. This window, which is not rational from a capital allocation perspective, given the amount of liquidity on the sidelines, will not last very long. Unlike the stock market, where it is very challenging, if not impossible, to “time the market” due to its extreme volatility, such is not the case in commercial real estate. It’s relatively easy to be out in front of the market and act quicky to preserve equity and redeploy where there is high arbitrage opportunity.
There are several institutional owners and lenders of high-profile office properties that are acting now to do just that. With very strong balance sheets, institutional equity, private capital funds and lenders can afford to “take the hit” now to reposition their investments where there is greater upside for profitable returns. Yes, the hit will not be pleasant and the pain, in some cases, will be severe, but it will not be life threatening and when this too shall pass, their performance will beat the market. They will have “pruned the tree” to survive this capital markets storm and be well positioned to thrive when the climate swings back in favor of growth investments. It will swing back. It always does. Cap rates will come back down fast as soon as greed overtakes fear. But a 50% drop in value takes a 100% increase in value to get back to even. Hence, time is always of the essence to accept reality and profit on fear.
So, are you an optimist….or a realist?
If you are a realist, we can help you survive and thrive!