2000 & BEYOND: Oldies but goodies

Several months ago, I had an experience that, in a religious context, would have been called an epiphany. I was meeting with a well-known New York real estate mogul and asked him how his business was faring. He answered simply that, "We're in an equilibrium market," and proceeded to discuss some of his views on the implications of this condition.

My first reaction to his comments was that his answer was quite astute. Upon reflection, however, I had a more profound interpretation. Commercial real estate is no longer the industry that the management revolution left behind.

How did the paradigm shift come about in the first place? What is driving us from moguls to managers? How will the industry be transformed in the future? What's the bottom line for commercial real estate as an industry?

Capital shifts Real estate has traditionally been driven by capital flows, whether created by tax law changes or old-fashioned, irrational exuberance on the part of investors. And commercial real estate has undergone a dramatic transformation in the source of much of this capital in the past five years.

Today, counting the existing float of REITs and CMBS, the total capital invested is close to $800 billion. That does not include all of the private opportunity and investment funds backed by institutional sources. As indicated in the Three Phases of Capital exhibit (opposite page), the initial shock wave was felt in the IPO boom of the early- and mid-1990s. More recently, the industry trend has been mergers and acquisitions (M&As) including both properties and operating companies.

The impact of this huge public and institutional investment in commercial real estate has permeated every aspect of the business from ownership to finance to services.

Only five years ago there were just a handful of REITs and real estate operating companies (REOCs) with capitalization worth more than $1 billion.Today, there are more than 50 companies with several over $10 billion in value. These REITs and REOCs have been recreated as operating companies with the attendant concerns regarding growth and profitability.Even smaller, private companies have felt the ripple effect of CMBS and institutional equity investment on their management style, disclosures and financial reporting.

The restructuring mandate The IPO boom and M&A moves were fueled by cheap capital and cheap real estate, two ingredients we can no longer count on. For the most part, the real estate markets are in equilibrium with capital constraints limiting new development. Moreover, given the size of the industry today, any new development is likely to have a marginal effect on value creation and profits.

We are stuck in a performance squeeze that echoes the challenges and changes that have transformed most other industries in the past decade. The change in other industries such as banking, insurance, steel and automobiles is called "restructuring," a dirty word in real estate.

As indicated in the graphic chart above, I believe restructuring - like the word or not - is the next wave for commercial real estate. Before we get too excited, consider the past five years of IPO and M&A activity. We have piled on assets and operating companies without taking much of a break to digest the contents. The good news is that we can look to the industries that restructured before us and later prospered for the lessons on how to get the job done.

Management and tech innovation Management and technology innovation have been the keys to successful restructuring in other industries. The starting point is to understand how our business works. Anyone who has ridden "shotgun" over the leasing process or worked through the preparation of a CMBS offering knows how information-intensive our business is. These facts are winning more and more recognition among other participants such as investors, servicers and even corporate real estate managers.

As we look closer we see archaic business processes that in many cases are simply broken. REITs should not take six months to prepare a budget. Mortgage conduits should not be reprocessed for the same information 50 times. Corporate real estate managers should not have to resort to three-month intensive projects to pull together asset information for transactions.

The good news is that reengineering is not rocket science; information technology is powerful, readily available, easy to use and relatively less expensive than in years past. Although basic, these high-tech fundamentals focus on transaction processing and enterprise accounting systems that most other industries have already embraced. In using these fundamentals, one of our clients was able to reduce its accounts payable processing costs by two-thirds.

There is more good news for commercial real estate in the recent management and technology innovations proven in other industries. These innovations include electronic commerce, supply chain management and customer management. E-commerce is just getting started in commercial real estate but will have an extraordinary impact on everything we do from finding deals to transaction processing to investor reporting. Consider the changes that will be brought about by "direct-push marketing" in an industry dominated by brokers and intermediaries.

Supply chain management is another area of tremendous potential. Think about how many light bulbs are used every year in a 50 million sq. ft. office portfolio. Rationalized supply chain management techniques, proven in other industries, have led to massive reductions in the cost of purchases and procurement processing, as well as substantial improvements in responsiveness and customer service.

Last, but not least, is a new management discipline called customer management. Recognizing that we actually have "customers" is a breakthrough in the real estate industry. We will need this new management approach and software technology to create "amazon.com"-type relationships with our new-found customers. Customer management will help us reach our customers, deliver more products and services, create greater customer value, and build brand identity.

Teaching an old dog new tricks I am convinced that the commercial real estate industry will take on the challenge of management and technology innovation and we will succeed. If we look closely at the attributes that have prevailed throughout the years, we find adaptability, resourcefulness and perseverance. These attributes will see us through the restructuring phase that we must endure. Who ever said that you can't teach an old dog new tricks?

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