Real Estate Rupture

Jarred Schenke

June 1, 2008

R ichard Bowers has lived through a few downturns during his career as a bulldog real estate broker. From the stagflation of the 1970s; the late '80s savings and loan debacle; the commercial real estate crash of the early '90s; and on through the technology bubble and the economic hardships following 9/11.

But in each downturn, Bowers - who owns one of the city's larger commercial brokerage firms and is a real estate legend in his own right - has been able to make good money. Companies still made decisions, moving offices or opening distribution facilities. 

But this time, things are a little different. Bowers, president of Richard Bowers & Co., is having more trouble eking out fees and commissions in this seeming recession. In fact, his firm failed to realize $1 million in projected fees from lease and property sale transactions during the first quarter. Those deals just didn't happen as he expected they would. "This [downturn] might be a little more problematic," he says. "I'm still optimistic, but maybe I'm not running as fast as I used to."

That's a chilling assessment coming from the man who personifies the art of the cold call. Bowers is admired and ribbed by many of his peers, who relish in sharing stories about his cold-calling exploits. So what he has to say about the economy is very telling. He falls short of calling the current economic environment a full-blown recession - but this downturn has teeth. And they're biting.

For the better part of a year, signs nationally have prophesized a coming economic downturn. As the housing market crashed and the appetite for risk among banks seized up, pundits and economists have debated and projected whether the United States was headed for recession. By the beginning of 2008, that debate morphed more into how long the recession would last and how deep it would be, as both the Bush administration and the Federal Reserve rushed to cut interest rates, stimulate the economy, and tamp down the fear within the credit and financial markets.

Whether this works remains to be seen. But the damage has been done, both nationally and in Atlanta.

With the metro area experiencing some of the nation's highest rates in housing foreclosures, companies serving the residential industry have been quick to contract and lay off employees. Atlanta's unemployment rate shot up a whopping 34 percent from March 2007 to March 2008, and the state's unemployment rate stood at 5.3 percent as of April, just edging out the national average.

The immediate pain clearly has been limited to the residential development, construction and financial services industry- especially mortgage companies, some of which have disappeared overnight. But talk with a variety of commercial real estate executives, and the sense is that fear is prevalent in corporate America. And in many ways, the commercial real estate industry is the frontline to what's happening in corporate America. Intrinsically tied together, as the business community slows, so does commercial real estate.  

Office Market Woes

For Atlanta's office market, the initial 2008 signs are disheartening. After experiencing more than 10 quarters of consecutive absorption- meaning companies are leasing more space than being left empty- the office market saw a sharp reversal during the first quarter of this year. Landlords were left with more than 300,000 square feet left unfilled. It's an ominous sign for a market that had remained healthy since 2004.

"I was hoping for zero [absorption], but we came a little lower than that," says noted Atlanta real estate analyst Richard Poland. "I don't see an incredible amount of absorption in the next couple of quarters. Everyone is saying the worst-case scenario is the end of '09. [But] the best-case scenario is the end of '08, before you start seeing a turnaround."

If that's the case, it can certainly get a lot worse before then, particularly in some areas of the city where five new gleaming office towers are under construction, with very few companies preleasing the new space.

"These situations always last longer than anybody thinks," says Bob Peterson, chairman of Atlanta-based Carter, a full-service commercial real estate firm. "We're in a recession for sure [and] it's going to last awhile. And in some sectors, it's just started."

Peterson echoes what many real estate executives say about Atlanta's corporate world - it's in a big pause. "We have a number of situations where companies have been close to signing a lease, and then said, ‘We're going to wait awhile,' " he says. "[This recession] is certainly going to last longer than the 2001 recession."

Peterson already sees signs of problems: companies cutting expenses and struggling to pay rents, and in some cases, even going belly-up, like the now defunct landscape retailer Pike's Nurseries. He expects the economy to worsen until it "bumps the bottom like a bathtub."

Wait And See

That seems to be the biggest immediate effect so far with the economy; companies have taken a wait-and-see attitude. Where once there were assurances of growth, confidence in both a domestic and world economy has been shaken. And with that, companies' desires to secure new space anytime soon.

"In a market where the economy is not showing good signs, you'd think this would be a great time for tenants to go out and make deals," says David Lanier, managing partner with CB Richard Ellis Group Inc. "But a lot of corporations are not making decisions."

Instead, they're inking short-term leases, ones that give them the flexibility to see how long before the market recovers, Lanier says. And this is one factor that clearly indicates we're in a recession.

"The economy is in a functional recession," says Bob Mathews, president of Colliers Spectrum Cauble Inc. "Between the media and all the discussion and the credit crisis, we're also helping talk our way into it, unfortunately. But it's real, and the effects on it are pretty simple."

While some companies remain on a growth path, most have become cautious and are delaying making long-term real estate decisionss. "With a few exceptions, most companies are being very cautious in taking any additional space and expanding. They're also looking for ways to cut costs," Mathews says. "Things are going to get progressively difficult because we're moving into the trough."

Sunny Side Of Life
Not every real estate executive is all doom and gloom. Some see the economy in recession, but remain hopeful the bottom will be quick and the bounce back up will be even faster.

"The time frame in which we went from business-as-usual to seriously in the tank was a very compressed time frame," says Clark Gore, the market director for Jones Lang LaSalle. "I think '08 is a year of looking for the bottom. I would like to think in terms of the compression going into the downturn, we would see a very quick recovery."

Gore also is optimistic that Atlanta - which has a history of weathering economic slides better than many other major American cities - will heal itself faster than the nation.

"The interesting thing about the real estate market in Atlanta is we tend to be late going into a recession and we tend to be early going out," he says."Most of our hiccups are just that - hiccups and pauses. Atlanta has been pretty immune to long-term downturns. We tend to take our lumps and get backon our feet pretty quickly.

"Some executives are even downright optimistic, although tempered with the knowledge that the economy is facing headwinds. "It's going to be challenging over the next 18 months, [but] we're in a more normal market,"says Mitchell Brannen, head of brokerage house NAI/Brannen Goddard. Brannen says the basic fundamentals of Atlanta's economy are in place,especially a rapidly growing population, which will "help Atlanta get through this cycle much cleaner than most cities."

Gene Anderson, senior VP and director of Highwoods Properties and one of themetro area's largest landlords, says the opinion of recession is fragmented,and has much to do with everyone's respective situation. And while the residential industry defied the laws of supply and demand and got into its own mess, he says most of corporate America was measured during the bull times in the past few years.

"Everybody feels that the market is soft, and they're cautious," he says. But as for Highwoods, the company has most of its office and industrial buildings comfortably leased with solid tenants, "so, we're pretty well pleased at where we are."

"I wouldn't call this a recession," says John Fetz, who heads up the Atlanta offices of The Staubach Co., one of the city's most prominent corporate real estate representatives. "While it has had an impact on investors in real estate - especially because financing has gotten very difficult - at this point, it's been limited. Our business was not off significantly, and we still have a lot of back log. So we're optimistic."

Different Reactions
Some developers - with projects drying up due of corporate demand - havemade cuts, most notably Cousins Properties Inc., which laid off a handful of development staffers, according to local reports. And those brokers in real estate investment have gone from feast to famine in a matter of months as the credit markets froze.

Steve Dils, executive VP and managing director of Grubb & Ellis, began to control corporate expenses two months ago. "What can you do without right now?" Dils says. "It's nothing Draconian. We're not slashing; we're not firing people. We're just watching the expenses."

"Like any prudent company, we're trying to be good stewards of our resources," Lanier says. "We're not making stupid cuts or stupid cost cutting decisions. We do have our eye on the big picture. But we also understand the reality of hitting your numbers."

While officials at CB and Colliers say they are only making strategic hires to help control costs, two other firms are actively pursuing new talent,including NAI/Brannen Goddard and Jones Lang LaSalle. "We're actually in an expansion mode," Gore says. "We're still looking to create the foundation of an industrial practice here."

Peterson says Carter saw this coming a year ago, and worked to make sure the company had enough cash on hand for any contingency. Seeing an opportunity, the company also is out seeking troubled assets to buy, with the idea it could take as long as five years before the project makes any money. Plus, it continues to engage in strategic developments, including the Piedmont Hospital campus in Buckhead and The Banks, a major mixed-use project in Cincinnati. "We just have to work a lot harder," he says. "We can't just go down the street and buy a site and put up an office building."

The Show Must Go On
Like many in the market, John Heagy, VP of leasing for Hines Interests L.P.,is aware of just how much corporate America is frightened. He also says this downturn will end someday, and commercial real estate companies need to be gearing up before the recovery.

"Who knows how long it will last? Even if it takes into 2009, that's not a significantly long period of time in the real estate business," Heagy says."In our industry, we have a very long-term view of our portfolios."

And Heagy even offers something more surprising. Despite high construction costs and very anemic office demand, Hines is still planning to come out of the ground with not one, but two new office buildings - 4004 Perimeter Summit, off Ashford Dunwoody Road in Central Perimeter, and Two Overton Park in Cobb County. Says Heagy, "If we wait until 2009 in absolute recovery,there will be three other developers who will be ahead of the game."

The interest in sustainable buildings is stronger than ever, and because the economic benefits are proving to be substantial, the move toward sustainability doesn't appear to be just another passing fad.

Sustainable (a.k.a. "green buildings") are designed and constructed to the highest energy and environmental standards. These buildings add value through, among other things, improvements in energy efficiency and environmental performance.

And the opportunities are ripe. According to the U.S. Green Building Council, the value of new sustainable building construction will exceed $12 billion in 2008 and is projected to increase to $60 billion by 2010.

The U.S. Green Building Council's Leadership in Energy and Environmental Design™ ("LEED") standards have become the de facto standards for constructing and renovating sustainable buildings. In addition to standards for new and renovated buildings, the council recently issued a LEED standard for existing ones that address a wide variety of sustainable design features such as energy efficiency, indoor air quality, and water use and reuse.

There are four levels of certification under the LEED standards: Certified, Silver, Gold and Platinum. A building obtains a higher level certification based upon the number of credits it receives on a LEED checklist (e.g., new construction versus existing buildings).

In addition to LEED certification in construction, there also is the U.S. Environmental Protection Agency's popular Energy Star™ program, which focuses specifically on energy consumption in existing buildings. Approximately 4,000 commercial buildings have earned the Energy Star label. Some of these buildings have cut their energy use by as much as 50 percent, and that increased efficiency can lead to substantial savings for the building owners.

Although obtaining LEED certification may require additional expense up front, the economic benefits from sustainable buildings can make the increased construction costs a sound investment. Sustainable buildings outperform other buildings in areas such as occupancy, sales price, rental rates and tenant retention. A Colorado study of LEED-NC (the standard for new construction) found that LEED adds 1 to 6 percent to construction cost. However, the value of energy efficiency offsets these costs in mostdevelopments.

In the Colorado study, net LEED benefits attributable to future energy savings averaged $2.70 per square foot. A California study found a modest initial investment of about 2 percent of construction costs typically yields a life-cycle savings of more than times the initial investment. This study found the 20-year net present value of LEED buildings was $48.87 per square foot for LEED Certified and Silver buildings, and $67.31 per square foot for Gold and Platinum buildings. 

Metro Atlanta also has experienced a rise in the construction of and interest in sustainable buildings. Atlanta's city government has taken an active role in promoting the construction of sustainable buildings. Mayor Shirley Franklin has stressed environmental sustainability is a key factor in making Atlanta a "best in class" city.

In 2003, the city passed an ordinance that requires all projects that are financed by the city to obtain at least LEED Silver certification. Also, a private foundation established the Sustainable Atlanta initiative to study programs and practices in other cities and make recommendations to city leaders.

The Arthur M. Blank Family Office

According to the city's Web site, Atlanta has more LEED certified or registered projects constructed or under construction than any other American city. There are 27 LEED certified buildings in Atlanta listed on the U.S. Green Building Council's Certified Project List, including the 171 17th Street office tower in Atlantic Station; The Arthur M. Blank Family Office; the New World of Coca Cola; and five buildings on Emory University's campus.

The 171 17th Street office is the first LEED Silver Core and Shell certified high rise office building in the world, and the Arthur M. Blank Family office was Georgia's first LEED Gold certified building.

Because of the increased focus on sustainability, the construction of sustainable buildings appears to be a long-term trend. All participants in commercial real estate markets should educate themselves and understand the issues surrounding sustainable buildings.

Rick Carter & Chris Thompson are partners in Powell Goldstein LLP in Atlanta, and co-chair the firm's sustainability practice.