As we begin to emerge from the devastation and tragedy of the pandemic, all Americans are dusting themselves off and looking to the future. We are all restarting our lives, making plans and perhaps using the lessons of the pandemic to change our priorities and behaviors going forward. Businesses are also regrouping, considering new strategies and directions, and a new approach to bringing employees together and creating culture. These changes are especially relevant for family businesses, where the personal and business goals often intersect.
Real estate family businesses are particularly intertwined with family dynamics, and many have been, and may continue to be, directly impacted by new patterns of demand for residential and commercial space, migration trends, and new areas of risk and opportunity in real estate investing. The economic and behavioral fallout from COVID-19 has had varying effects on each market, property type and building. As such, each real estate family business experienced different challenges.
This is the right time for family leaders to consider how the well the business responded during the past year and what lessons could be learned, particularly in the way the family communicated with one another as critical and often difficult decisions were made to preserve asset values and cash flow. This article provides guidance on areas of focus when rethinking both family and business matters in the post-pandemic real estate environment.
Reassessing investment strategies
Real estate owners have recognized that the pandemic shifted the demand for space across property types. Multifamily properties in gateway cities reliant on public transportation saw a significant out migration of tenants, not all of which will return. The pandemic accelerated the move of older millennials to the suburbs, and even before COVID-19 struck, new rent regulations in states such as California and New York made it more difficult to achieve required returns from apartment renovations. The oversupply of retail in many markets became even more pronounced. And the strength of office space demand is uncertain as tenants experiment with more permanent work-from-home or hybrid scenarios. Hotels suffered the most immediate impact of the lockdowns, and while leisure travel is coming back strong, the restoration of business and group travel demand is impossible to predict. Conversely, many industrial and self-storage properties are performing above pre-COVID-19 levels.
The new market dynamics require refreshing real estate company strategy. Many owners are looking to new markets to find better opportunities, changing their investment targets to new property types, planning to repurpose space or searching for elusive distressed situations. Such strategic shifts can only be successful if the company has the right platform—local relationships, access to data, analytical tools and reporting, and capital availability—to optimally implement the changes. Companies are also taking a hard look at their existing portfolios, reforecasting budgets, modeling prospective cash flows and capital requirements, and potentially adjusting expected returns.
A key consideration in buy-hold-sell decisions today is a property’s ability to hedge against a likely inflationary period; that is, the owner has the ability to grow rents along with or exceeding the inflation rate. An assessment of property competitiveness and actual vs. market rent variances in the current environment will become even more important in the next few years. On the expense side, the cost of goods and services is already rising, particularly in construction and rehab. During the pandemic, management companies already made substantial efforts to trim operating expenses and boost efficiency. These efforts will become even more important in an inflationary environment that brings a continuous need to control costs.
Another consideration of heightened importance is whether the family business has devoted sufficient attention to the Environmental-Social-Governance (ESG) requirements of growing numbers of capital sources. A LEEDS certificate in the lobby is no longer enough. Investors are concerned with both reducing the portfolio’s carbon footprint and knowing the company has drafted principles and policies that provide equal opportunity to a diverse group of employees and benefit the community at large. ESG is changing the way all companies operate and communicate their efforts, creating accountability for vendor selection processes, employee advancement, tenant safety measures and, of course, carbon efficient building designs.
During the pandemic, the greatest concern for many property owners was liquidity; cash flow was squeezed by lower revenues and static expenses. Most owners were able to modify debt terms to ease the shortfall, and many achieved a total forbearance of payments. However, such modifications are temporary and ultimately, the payments and reserve balances must be made up. Management should particularly focus on mortgages with short-term maturities. While the debt markets are fully open, underwriting has tightened and, in some cases, interest rates are higher. If the value of your property has fallen in the last year, refinancing may be more difficult, depending on leverage. An equity infusion may be required to exit the loan as an alternative to expensive bridge financing.
Of particular concern in real estate family businesses, cash shortages often translated to a partial or full cut in distributions paid to family members and limited partner investors. Accordingly, company management should be updating their cash flow models, projecting revised short-term and longer-term income streams based on revised rent and occupancy assumptions, anticipated collection of past due rent, operating expenses, capital budgets and debt payments. In this way owners are prepared for communications with their lenders and can set expectations for family members and outside investors. The revised projections can also be used to monitor debt covenant compliance, an analysis that has also taken on greater importance.
The pandemic also brought to light two areas of required focus for real estate business leaders: fraud prevention and cybersecurity. Studies have shown that real estate had the second highest median fraud loss of any industry in 2020. Family businesses often do not have the same internal control and fraud prevention processes as institutional players. Further, the internal control environment can be weakened when employees are working from home. The stress caused by the pandemic, furloughs and pay reductions all have the potential to motivate employees to commit fraud.
All companies, irrespective of size, are vulnerable to cyberattacks. While not new, there are increasing numbers of publicized successful attacks on what would be thought of as companies with enhanced security. As family businesses implement more property technology alongside management and accounting software, they also have to invest in security platforms to control and protect the entire IT environment. Additional oversight, enhanced training (most security breaches result from unintended employee actions), avoidance and protocols for ransomware are all components of an effective IT security plan.
The challenges all families went through in the last year emphasize the importance of empathy and good communication. That is equally true in a family business, particularly in real estate, where property ownership is often shared among many people. Frequent family meetings and enhanced reporting can be used by leaders to explain changing strategies and the rationale for critical decisions that impact family members, including distributions. The more information that can be shared, the better—to preserve family harmony and avoid conflicts during difficult periods. It is possible that during the pandemic some family members had conflicting views on how the company should be dealing with tenants, vendors, lenders and investors. Providing a forum to air dissenting opinions and formally resolving such disputes can strengthen family bonds and avoid on-going resentment. Behaviors during the pandemic may have reinforced the need to create or refine family governance, including delegations of authority and richer reports.
The past year also stressed the need for enhanced emergency preparedness protocols. Tragically, some families may not have been sufficiently prepared for a sudden leadership succession, both within the family and among management company employees, and difficult decisions had to be made in the midst of the storm rather than during a period of calm waters. Family meetings afford the opportunity to assess skills sets and have honest discussions about the future leaders of the family business.
The realization that family members’ health or even lives could be vulnerable to sudden events outside their control is unsettling, and part of emergency preparedness is creating a “desk plan” for all members of the family. A desk plan organizes the information required if a family member dies or is incapacitated. It provides a roadmap to important information and documents that are essential for an easier transition during a difficult time. A typical desk plan includes the location of contact information, passwords, estate documents and investment account statements. For a real estate family, the desk plan should also provide access to property performance data, management contracts, lease databases and critical financial records. The availability of these documents will enable the heirs to maintain operations and mitigate any risk of business interruption.
Estate planning is also a critical to provide for and protect family members. Recently proposed changes to the taxation of capital gains and like-kind exchanges require careful monitoring as they would significantly impact the heirs of an estate with real estate holdings. If enacted as proposed, capital gains on assets held by the decedent would be triggered upon death, the current step-up in basis would be eliminated, the capital gains tax rate doubled and like-kind exchanges limited. This combination of changes would require significant liquidity to pay the gains taxes at death, and therefore might influence both real estate investment and tax strategies, as well as asset diversification.
Action steps: the post-pandemic checklist
As you dust off the pandemic and consider the future, have you taken the following actions for your business and your family?
- Refreshed your business strategy
- Assessed the adequacy of the business platform to support the company’s new direction
- Reforecast property budgets and assessed cash needs
- Analyzed the potential for refinancing loans with near-term maturities
- Identified potential operating expense savings
- Assessed the adequacy of internal controls
- Competed the Real Estate Fraud Prevention Checklist
- Analyzed ways to reduce the portfolio’s and the company’s carbon footprint
- Created a statement of ESG principles
- Held a family meeting to discuss the company’s performance during the pandemic
- Reset family member expectations about investment returns and cash flows
- Refreshed the family’s governance documentation, including succession plans
- Considered ways to enhance family communication, including regular reporting
- Developed emergency preparedness plans
- Encouraged all members of the family to prepare a desk plan
- Updated your estate plans
- Spoken with your tax advisor about the proposed income tax changes