PERSPECTIVE ON THE ECONOMY AND ITS BUSINESS IMPACT

By Tiffany Wright

Have you wondered how, when you read about the quarterly performance of publicly held companies, the revenues could shrink but net income would be up? Sometimes this is simply due to the recognition of a one-time large expense for layoffs, asset writedowns, acquisitions, etc. in the previous quarter that does not repeat in the following quarter. For many others, however, the company either lost customers or customers did not buy as much as they did previously, thus resulting in a dropoff in sales. Having foreseen this, the company re-focused its attention on its operations and the accountability of all its various departments and reduced costs and increased efficiency and productivity. These activities reduced fixed and variable costs resulting in a significant reduction in expenses. This drastic decrease in expenses more than offset the decrease in revenue, leading to an overall increase in net income. In the current economy where there is a lot of pressure on top line revenues, such an occurrence is a good thing.

Yes, the economy is suffering. Many economists and other pundits constantly weigh in with their speculations on what will happen over the next one to two years, how long it will take to “recover”, and how bad it will get. The level of negativity in the business and financial press is at an all-time high with daily dire predictions. However, as any good business person knows, all economies are cyclical. A time of expansion with rapid creation of goods and services and rampant building and development  is always followed by a contraction in which the pace of creation drops which then allows for the absorption of that which was created during the expansion period. When something is significantly overbuilt well beyond what the market can absorb, the contraction can last several years.

This happened in the telecom industry which rapidly expanded in the late 1990’s to accommodate demand from Internet companies that built out infrastructure based on projected customer usage. When that usage failed to materialize many Internet companies failed, dumping underutilized telecom capacity and used telecom equipment back on the market and bringing down many small, medium and a few large telcos in the process. The equipment was absorbed in a few years but the network capacity is still being absorbed.

How does that relate to commercial construction? In some areas of the country and the state residential construction has plummeted due to a confluence of factors. It is the reverse of the same perfect storm that created the residential building boom. In late 2005 many of my former real estate investment peers (I exited the market earlier that year) were complaining about being unable to sell or rent their renovated properties due to the high number of brand new properties on the market.  Hard money lenders began taking hits because the investors could not execute on their exit plans. In July and August 2005 I interviewed a number of large apartment owners in the Atlanta area, those with 2,500 – 10,000 units. The concensus was the same: Do not enter the market unless you can maintain a debt to equity ratio of 60%. Since most properties at the time were purchased with 80% debt financing, that was a strong statement. You either infuse a lot of equity into the property or buy at a very undermarket price. Why did they say this? Because interest rates were so low and so many builders were offering near 100% financing that their target apartment dweller could qualify for a loan with almost little down and have payments that were the same or less than what they had been paying in rent. One owner had a new 250-unit apartment complex in the near suburbs just outside I-285 that enjoyed nearly 95% occupancy. However, a developer purchased the land across the road and built a townhome community then directly solicited the apartment tenants. The 2-bedroom rent was $650; the 2-bedroom townhome mortgage payment was $599 per month with the introductory low interest rate.  The complex’s vacancy rate doubled. The complex reduced its rent to $595, included 1-month free, and added other amenities to stop the loss. This worked but obviously significantly impacted cash flow. Hence, the recommendations for 60% debt-to-equity.

Residential home construction typically precedes commercial retail construction. Retail centers need people who live in the area to patronize their establishments. Many retail entities followed the same rapid expansion as the residential construction. Those with the most aggressive expansion campaigns with the most debt or undervalued land holdings have been impacted the greatest. Thus, the dropoff in the commercial retail sector is large and expected to increase. Most of this dropoff is / will be felt in the outer suburbs of Atlanta where the plummet in residential construction is the greatest.