Two years ago, Gary Schwandt was working for a Boston firm called PCA Realty Advisors when the company was acquired by Dallas-based Prentiss Property-Realty Advisors. Schwandt then moved to Prentiss, which, a year later, acquired New York-based Baring Institutional Realty Advisors. Prentiss reorganized and changed its name to Acacia Realty Advisors Inc. Schwandt is now a senior managing director of Acacia. "There are mergers and consolidation in the industry and I'm part of that," say Schwandt.
Graham Bond, chief operating officer with the Yarmouth Group in New York, is a part of the changing industry also. His company was taken over by the Australian firm Lend Lease Corp. in 1993. (A "strategic alliance," as he says.)
The institutional real estate advisory business, including those companies that do asset management, has been stirred lately. Mergers and consolidations are changing the face of the industry; the mechanics of the business have changed. The nature of adviser-client relationships also has changed. The roots of the changes probably can be found in the recession of the early 1990s, which altered the face of the real estate industry. The changing dynamics put pressure on the asset management industry, as well.
The role of the asset manager was to create value for properties, especially those held by institutional investors, explains Phil Rogers, senior vice president of Axiom Real Estate Management based in Stamford, Conn. But with the recession, value was lost and property owners put some of the blame on the asset managers. Now, Rogers says, the role of the asset manager is t secure value. Asset managers find themselves reaching out to owner ship, providing more service and information keeping owners completely apprised of current investments.
"Nowadays, owner are looking for detailed line by line analysis as to what your income expenses would be and they want it tracked very closely during the year," says Daniel McConnell, director of the Institutional Management Group at Williams Real Estate Co. in New York. "Owners, in particular institutional owners, expect property."
Asset managers are moving into the property management business to make sure the management of individual properties is cohesive and strategic. Asset managers are getting down onto the field level and are becoming more involved in things like lease transactions, observes Brett Hunsaker, senior vice president with Koll Management in Atlanta.
Tom Elmer, chairman of the asset management committee for the Institute of Real Estate Management (IREM) and senior manager at Chicago-based Deloitte & Touche, says a trend he sees is that the industry is moving to the opposite side of the spectrum from where it was in the 1980s. "When there are bad things happening people tighten the controls," he says. However he says that he thinks it's a 50/50 split between asset managers taking more control and asset managers delegating more responsibilities to property managers. "Some asset managers are getting less involved because of cost," he says.
To some extent, there is verticalization of asset management work, or a bundling of services to include asset management, property management and facilities management.
Northwest Asset Management Co., based in Walnut Creek, Calif., boasts that its services address every facet of real estate management from property, construction and facility management to asset management, where it acts in partnership with its clients to provide strategic direction and implementation. There always has been some cross-pollination between the different disciplines, notes Richard Calhoun, vice president of Northwest.
Currently, there is quite a bit of debate on the subject of bundling services, notes Brian Murphy, managing director with Prudential Realty Group in Newark, N.J., particularly when a company is able to place a significantly lower bid on a portfolio than any other competitor under the assumption that the low-bidding company also would get the property management and leasing business of the portfolio.
In situations where the asset manager and property manager are the same, how does the former fire the latter if the building is not leasing?
Vertical integration offers a big economic advantage in terms of information gathering and decision-making, says Acacia Realty's Schwandt, but the conflict is: How do you fire your property manager if it is yourself? "It is a legitimate concern and raised by pension plans all the time."
Despite potential conflicts of interest, "big and diversified" seems to be the ongoing trend. "The more services you offer, the more opportunities you have to get invited to the dance," says Jim Gorman, director of corporate development for PM Realty Group in Chicago. "That's basically the theory and apparently it works."
"Compression is occurring since the returns and yields on real estate have not been as favorable of late," says Hunsaker. "There is vertical penetration," but he adds, owners need to make a distinction, because the asset management function is an integral, long-range, strategic management of portfolios. What that may entail, however, is improving the performance of the individual properties, and that is getting down to the property management level.
Property managers get into the asset management business for two reasons, explains Axiom's Rogers, "The better property management firms are the ones that are not only able to manage property and occupancy issues, but also add value and strategic financial analysis." The combination of the two functions are the basic requirements for any property.
New York-based S.L. Green Real Estate Inc. is often hired by asset managers to do property management and leasing, but as Stephen Green, founder and chairman of the company, says: "We've always done a combination of both asset management and property management. We don't distinguish."
When managing an asset, Green says, managers really are creating income for that asset, which means regulating, monitoring and reducing expenses and getting income to grow.
Property managers create value
"We actually get involved in leasing space, managing operations, reducing expenses, cutting labor, adding staff, modernizing buildings and renovating properties," Green explains.
Mitchell Rudin, a senior managing director and director of the Gordon Property Group in New York, says his company does "enhanced property management" because it has assumed a lot of the responsibilities that were traditionally done by the asset manager. Asset management companies have downloaded a lot of their responsibility to property managers.
"As we moved into the 1990s, the real estate industry was changing and different requirements were being placed upon us - much more stringent requirements for reporting and budgeting - and we were being asked to advise as to product positioning and the establishment of an exit strategy", Rudin says.
There is an element of property management/asset management as companies in the pursuit of doing more business have sought to claim that they will do both, says Yarmouth's Bond.
"It is not always clear what the difference is," Bond says, although he firmly delineates between the two, explaining that asset management is really about the development of a strategy for the assets.
Development companies branch out
A number of development companies with nothing to develop have branched into management, just asfirms looking for ways to generate more income have entered the asset management business.
Such developers as Hines, Lincoln Property and Trammell Crow have been successful in replacing development income with third-party asset management fees. It was a logical step, since developers already had experience managing their own portfolios. However, says Northwest's Calhoun, "It is generally more difficult for property managers to move into asset management than vice versa, since asset management is financially oriented, while property management is operationally oriented."
This difficulty hasn't stopped property managers from moving up, which has increased competition in the industry.
"The crowding effect has squeezed down a lot of small firms and companies that weren't doing well," says Williams' McConnell. "It's tougher for small firms to get by now, unless they have a specialty such as a particular asset class or a certain property type."
Tishman Hotel Corp. in New York is an asset manager in a special niche. It only provides asset management service for the hotel industry and its clients are domestic banks, insurance companies, domestic hedge funds, foreign banks and private investors. Part of its job is to find or maximize value, especially in situations where it gets hired to be a long-term asset manager. But, Tishman also will be hired by companies that are forced to sell-properties. Then, Tishman's asset management efforts will be focused on maximizing cash flow and disposition proceeds all within a six- to 12-month period.
"There are two kinds of asset management, says Tom Arasi, executive vice president of finance and development for Tishman. "There is general hand holding, which we don't do and could be done by pure consultants and brokerage firms. Then there is in-depth asset management, which we do." He says that the latter is strategic and intensive.
While asset management, as a discipline within the real estate business, expanded and became over-competitive with a lot of new players in certain niches such as the hotel industry, "you can put on one hand the number of people who have a national name and are doing asset management," Arasi notes.
The big companies may be getting bigger due to consolidation in the industry, but because so many funds are devoted to real estate of all types, Edward Milton, regional president of Koll in Atlanta, says, "there is room for niche players."
Competitive pressure on the asset management business also is coming from non-industry sources. Reportedly, a few plan sponsors have taken the asset management business in-house, utilizing their own staff to do the strategic work that generally was done by the outside service provider. In addition, with Wall Street playing a larger role in the real estate business, the dynamics of outside adviser relationships have changed as well. The most obvious examples of this change have been where Wall Street companies, or funds run by investment banking firms, formed their own asset management subsidiaries.
As in any industry, competitive pressure usually means that the cost of services will drop as one competitor tries to gain market-share by reducing fees. While this competition may be salubrious for clients, service providers usually find themselves in a price war, sometimes irrevocably damaging each other's bottom line.
Fees have been under pressure in all financial service industries, Bond observes. "It is a function of the times." However, in the asset management business, fees have also come under pressure because of the competitive pricing asked by new entries in the business. More companies who are willing to work to attract business are getting into the market, rather than those who work to earn the company a profit or a reasonable return.
Part of the problem with fee structure is that many companies that are competing for business are part of the whole paradigm shift to integrated services. "These people are breaking even or losing a little bit of money on the asset management part of the business, expecting, instead, to realize significant fees at the property management level," says Prudential Realty's Murphy.
If a company is not competing for the complete package and is just competing for the asset management work, the fee structure is driven down. If a bidder can get the leasing and property management to an attractive fee schedule, the asset management services can be delivered for less.
There has been significant fee pressure from plan sponsors who are very inclined to look at compensation more on a performance-related basis than ever before.
"In a lot of contracts, compensation now is tied to the success of the real estate," says Koll Management's Milton. "Compensation can be tied to performance."
In the past, fees generally were related to value, but that ratio has become very controversial, especially since some companies were alleged to have inflated the value of real estate under management. Quite a few companies have moved away from determination of appraised value to performance-related elements, so there isn't a dependence on value and the difficulties and controversies that have risen because of it, Bond says.
Investors force industry efficiency
Institutional investors have forced the asset management industry to become more efficient and this, in turn, has caused fees to slide downward - mostly because asset managers now are doing more work for basically the same, or less, compensation. "This is a national trend. It just took a while for it to catch on in real estate," Gorman says. The beginnings of the downward pressure on fees, to some extent, came from the Resolution Trust Corp. When the government started forcing vendors fees down, Wall Street began forcing fees down, and eventually institutional investors did the same.
"Right now, asset management is not a very profitable business," Murphy says, not just because of competition, but also because of the changing nature of the real estate business. Since clients' expectations have changed, they demand a lot more from asset managers. Clients also want tighter controls on managed property, more detailed information and better financial reporting.
"In the past, an owner might have told the asset manager,Just run the property as if it was your own. If you have any expenses, just let me know about it and we'll talk it over'," McConnell says.Now they have a cut-off on expenses and want to talk over every detail. Owners are more focused on performance of the asset and working closer with the asset managers, making sure they are getting the best performance out of them."
A recent survey of asset managers by Axiom Real Estate Management reports:
* Instituting cost controls and reducing high vacancy rates will be the two most challenging issues facing asset managers in 1995.
* Other frequently cited problems are the related issues of reducing occupancy costs, maximizing values, increasing yields and cash flow and stabilizing properties acquired through foreclosure.
* Asset managers are concerned with rising interest rates, high real estate taxes, competition and being able to react quickly to changing business conditions.
* Operational challenges include increasing services, finding good management firms and hiring qualified people.
As the nature of the asset management business has changed, hiring qualified people has become a vexing problem. "Asset management is evolving, but finding qualified professionals with both tangible real estate and finance experience can sometimes prove difficult," says Lawrence Corson, vice president and director of real estate for the J.E. Robert Cos. in New York.
Sometimes people have to be added quickly. J.E. Robert saw one joint venture portfolio in 1994 swell from 50 to 300 assets, comprising 17.5 million sq. ft. of commercial space and 13,000 apartment units, resulting in the hiring of 40 new employees. "We have found that good asset managers can almost be like capital gypsies. Offshore investors and pension funds were the owners of the 1980s. Today, more of the new capital is coming from Wall Street. This change has altered the skill set required of asset managers," Corson says.
The parameters of the asset management business are indeed changing and the companies that adjust fast enough are the ones that will survive the 1990s.
Steve Bergsman is a Phoenix-based writer who contributes regularly to National Real Estate Investor.
Environmental Aspects of Commercial Mortgage
Loans from Wall Street Funding Sources
Commercial property owners increasingly are obtaining less expensive mortgage financing from Wall Street investment banking houses instead of from conventional lending sources like banks or insurance companies. For example, in the past two years, owners of properties leased to K mart have borrowed over $750 million through securitized financing.
These transactions often involve pools of properties and different borrowers, as well as differing state laws and practices. Not surprisingly, these factors present enormous challenges in assessing and understanding the environmental risks on each individual property and on real estate pools as a whole. Closing these transactions is, therefore, quite challenging.
Strict liability under state and federal Superfund law creates material risks of owner and operator liability. This risk is difficult to quantify because there is insufficient legal precedent to shield borrowers from Superfund liability. For known risks (such as on-site clean-up actions), it may be necessary to establish reserves for post-closing response actions. For unknown risks, satisfying legal due diligence requirements pertaining to off-site risks is still difficult. Although there is emerging precedent that an owner's property contaminated by an unrelated third party through the migration of a groundwater plume may be immune from Superfund liability, such legal comfort is not well defined. For unknown risks, site assessment insurance or pollution insurance may be valuable.
As a threshold matter, environmental risks of the overall transaction must be disclosed to investors in the securities prospectus. Since investors are essentially the lender, the environmental disclosure in the prospectus should apprise the investors of the environmental risks associated with real property collateral. The lien risk under the federal Superfund statute, as well as related risks under state statutes, should be disclosed. The evolving standard of liability of a secured lender under Superfund laws should be disclosed. The obligations of the servicer of the loans in dealing with potential contamination conditions during the term of the loans should be disclosed. The relevant representations and warranties, indemnifications and other environmental provisions in the loan agreements and the leases also should be disclosed.
In order to get the securities rated by a rating agency like Standard & Poor's, Moody's or Fitch, environmental site assessments need to be performed. In a mortgage-backed securitized loan transaction, in which the securities rating is based upon net income from the mortgaged properties, a hazardous waste condition giving rise to a material liability of one of the borrowers can dramatically distort the ratio of income to operating cost of that property. Accordingly, the rating agencies require a high level of comfort that unexpected environmental conditions do not exist which will alter the anticipated ratios.
In a lease-backed securitized loan transaction, theis structured based on the credit of the tenant and the economic value of the leases. An environmental issue which could jeopardize a tenant's obligation to pay rent for the balance of the lease term creates a serious issue in underwriting the whole transaction. In these transaction one must look beyond the environmental law governing the property owner's or tenant's liability. Legal counsel should consider the relevant lease provisions and state law interpretations of such lease provisions to appreciate the significance of an environmental condition giving rise to a tenant's right to withhold rent, or, at worst, terminate the lease.
Commercial property owners interested in pursuing securitized financing where an environmental issue is suspected should begin by consulting with experienced legal counsel about an adequate level of due diligence to meet Wall Street standards.
Franklin G. Stearns is a partner in the environmental practice group at Brown, Rudnick, Freed & Gesmer.