Construction and Development Roundtable: Facilitating a Facelift

In Business magazine convened an expert panel to discuss the latest trends in the industry that is changing the face of Madison — construction and development. If the Constellation and the newly renovated Edgewater Hotel are any indication, there is immense public curiosity about the looming cranes and rising buildings that are giving Madison’s skyline a new silhouette.

Since our last Construction & Development Roundtable, much has happened, including the addition of more stunning structures, the adoption of a new tax incremental finance (TIF) policy for the City of Madison, and the beginning of a phased rewrite of the Madison Landmarks Ordinance. These developments all hold long-term promise, but there are more immediate trends that will influence whether we can maintain the current pace of commercial construction, and whether new office construction will make a comeback.

Addressing the possibilities are moderator Joe Vanden Plas, IB editorial director, and an expert panel that includes industry executives Ron Becher, president, JP Cullen; Brad Hutter, president and CEO, MIG Commercial Real Estate; Joe Alexander, president, The Alexander Co.; Verne Jesse, attorney, Murphy Desmond; and Eric Schwartz, president, Sara Investment Real Estate.

Maintaining the pace

VANDEN PLAS: What do you envision for the level of construction activity in the next year, and then looking over the horizon, for the next three years?

BECHER: The way I look at it, and definitely from the construction side, I would see it increasing. We’ll pretty much follow what the economy is doing. It’s projected to increase, still grow, through maybe 2016. Some of the things I look at are the state, mainly the [UW-Madison] work. There’s going to be about $150 million of work bid and starting within the next 12 months, if they stick to their schedule. That’s fairly significant. It would replace all the work on the buildings that are going up in town and all the tall cranes you’re seeing. It would include Memorial Union phase 2, in addition to the UW Hospital parking ramp, Meat/Muscle Science [biology laboratory], and Babcock Dairy. Some of it is new, and some of it is just modernizing and upgrades.

JESSE: The things that have made growth so consistent in Madison remain the seat of government, the university, the number of good-paying white collar jobs, and the fact the economy here seems to be less prone to the bigger dips that you see in other parts of the country. On that basis, I would expect some continued growth both on the one-year and the three-year horizons. One thing that always causes me to pause in this economy is that surveys seem to show, whether it’s business owners or consumer confidence surveys, the perception that this quote-unquote recovery is fragile. So something that on a purely logical basis shouldn’t have a negative impact could in fact have a negative impact, and that concerns me.

SCHWARTZ: If you look at the history, the short-term history from the decline [when] Lehman fell in October of 2008, if you look at the private-sector development and how many times we called JP Cullen for work in 2010, 2011, 2012, we’ve been filling space. Our corporate occupancy is at 91%, 92%, so we’re out of space. We’re going to start having to construct buildings for tenants, or expand. So as the occupancy grows, as our tenants run out of space, we have to start calling JP Cullen to build buildings, and that is going to occur in 2015, 2016, and beyond.

The thing that is slowing the economy, the thing that’s puzzling me, is why we’re not growing a little bit more, a little bit stronger. Part of that is leverage. There’s so much leverage in the market. The QE2 [quantitative easing], QE3 programs, there were a lot of benefits to it and a lot of negatives to it. If you look at other [economic] rebounds, we have rebounded faster, and we all thought it would happen a little quicker than it has, and it really hasn’t.

Just debt in general. The average consumer, the average company, the government, we’re all more debt-laden than in any other recovery in the last 80 years, percentage-wise. The wonderful thing about QE is that it pushed down interest rates, got everybody thinking a little bit more positive. The bad thing is, we got a lot of debt, and it’s slowing our growth. That’s not allowing us to grow as quickly as you would think with 91% occupancy.

HUTTER: There are developers, still commercial real estate owners, that are still trying to dig out of 2008 to 2012 by filling spaces or selling off. Now that some valuations have come back and capitalization rates have dropped, and some of the values of some of their buildings are coming back up, they’re able to finally sell them and maybe get something out of them.

We’ve been able, over the last number of years, to fill some of those areas where tenants have contracted or maybe tenants went out of business after Lehman. We’ve been able to build those occupancy rates back up into the 90s. Money is flowing into real estate, more as an investment vehicle now than before, from large institutions.

That then pushes capitalization rates down, which pushes values up. Owners are now able to refinance their buildings and potentially take some equity out, or have some more flexibility financially.

Tenants have been relocated to different buildings and are allowing us to move their occupancy rate up. There hasn’t been a lot of speculative office building at all, which of course assists the developers and landlords in leasing out their spaces. That builds a general foundational stability in the overall market.

As we get into the 90s with our occupancy rates and we are running out of space, larger tenants, or tenants that need to expand, or tenants that are coming to us with opportunities, we may not have that. You’ve got to have that space available. One option is then to go out and purchase something existing and renovate it, which again helps the industry in that there might be other developers out there who need to unload something.

Then we have the capacity to refinance and create liquid capital to renovate an existing building, or to go out and sign a lease in order to underwrite the construction of a new office. And then there would be some speculative portion typically attached to some of those projects, which would add some square footage, whether it’s 20,000 or 30,000 or 50,000 square feet of additional opportunity in the market for future leasing.

Right now, other than a little bit of a bump, interest rates continue to be historically low. Well-run businesses continue to stockpile money, large ones especially, and build capital. Some larger businesses — I’ve seen more than ever — are now in a position to make some pretty significant moves, take advantage of the market, and do large projects.

We’re seeing residential because the timing on a residential plan is much shorter. When Eric or Joe and I work with a larger corporation, their planning for a building goes out sometimes almost two years. It’s not something you throw together in six to nine months. So you may see the apartments going up now, but there’s a lot of [office] planning happening.

(Continued)

VANDEN PLAS: One of the reasons companies were sitting on cash is because they hedge about the availability of bank financing if they have to move. So can they do it with cash on hand?

HUTTER: It’s just the visceral reaction to getting slapped like we did in 2008. So everyone organically knows that when the economy dropped that quickly, cash is king. The more that you can stockpile, the better. We saw a dearth then of the small to small-medium businesses that didn’t have that capital from 2008 to 2012, those businesses of eight to 12, 12 to 20, and up to 35 people that would typically go into 6,000- to 12,000-square-foot spaces down the road. They were so hurt, or maybe put out of business, there’s kind of a dead spot there.

ALEXANDER: There’s a big psychological hangover. People are keeping cash because they want a cushion if something happens. A lot of tenants simply shrunk in place, and what you’re seeing happen now is they’re growing back to where they were in 2007 in terms of the amount of space that they need and are occupying. They’re doing it more slowly, and they’re putting more people in less square footage, and so everybody’s still being pretty frugal. People talk about the next [liquidity] bubble, and it really has to do with equity and debt. I don’t think it has much to do with local or medium- to small-sized businesses getting too far ahead of themselves.

Marking the market

VANDEN PLAS: In this forthcoming period, what market segments do you expect to change the most?

SCHWARTZ: We have industrial, office, and retail. We don’t have anything with a pillow, so no apartments or hotels. The first to recover was the industrial; we have zero vacancy in industrial. The next was retail, and the lagging one is office. There are still some office opportunities for us as far as buying power, but here’s the kicker on office. The office is related to the job market, and our firm had, as of last week, seven job openings, and we can’t fill them fast enough. It’s hard to find the right people. To fill a skilled position is difficult, and in the office component, it’s really difficult, and that’s going to slow the filling of those office spaces. Here’s the thing that’s going to trouble all these companies: Is the skilled person even out there? That’s the $64,000 question.

VANDEN PLAS: In your case, what positions are toughest to fill right now?

SCHWARTZ: For us, the analyst position, that type of position, and property management — those are tough positions for us. Even our front desk position, it was four and a half weeks until we found somebody. That was painful.

BECHER: Hundreds of applicants to go through.

SCHWARTZ: Quality is the issue.

HUTTER: People often think that in real estate, developers and owners only want to build or renovate where they own land. In fact, very often we are targeting an area that has advantages for business, whether it’s industrial, retail, or office. One of those key aspects is whether it’s easier for these businesses to hire people in that spot. As there’s been a renaissance in downtown Madison, as people have come back to downtown Madison for all sorts of reasons, it’s easier to hire downtown because it’s got a cachet to it now — restaurants and all those different types of things. It all works together to assist a business in hiring. If a business has an easier time hiring in the central areas, that’s an advantage in being selected for a project.

BECHER: With some of the other markets, the local K-12 school district is looking to go to a referendum for $24 million, which isn’t very significant, but in the past five years Madison has done almost nothing. And health care is a place where there’s going to be a pent-up demand, only because there’s a lot of consolidation going on and just the uneasiness of what’s happening with health care. There’s a lot of waiting to see what’s going to go on, but that’s an area that’s going to have some good growth, not necessarily this next year but in future years.

SCHWARTZ: I’m on a bank board, so I see it from two sides. If you want to know what worries me, it’s that the liquidity is flowing too quickly back to us, so we can get liquidity fairly easily and at terms that are concerning. In other words, they’re too favorable if you’re short of equity on a project. Because of QE2 and QE3, the interest rates were pushed down. You have the investor sprinting toward yield and just not really looking at risk. So there’s more money in the system than ever, so we can get liquidity.

What I worry about is the shampoo economy — lather, rinse, repeat. We get all this money coming in and we’re not thoughtful or disciplined about it, and we just aren’t using it. Recently, I had a lender offer an extra five points to me in liquidity that I didn’t need. But you’re thinking, ‘Well, their money’s cheaper than mine’ and all those things are running through your mind. What worries me is that we’re just kind of heading down that same road.

VANDEN PLAS: A repeat of 2008?

SCHWARTZ: Well, all of a sudden you have this kind of, especially in the apartment side, and I’m not really skilled at the apartment side, but when you drive in downtown Madison, you can tell the landscape is different. It looks like nothing [we remember], and we all grew up here, we’ve all been here for 30 years. I’m like, ‘Oh, my goodness. Are you kidding me?’

JESSE: Can it happen that quickly, though, the shampoo economy?

SCHWARTZ: I don’t know. Not quickly, but will it happen? If rates rise a little bit, that might actually be kind of a nice way to kind of tap the brakes. That might be okay. I don’t know.

JESSE: That goes back to the psychological component we were talking about before. That tends to weigh against, to use your analogy, the shampoo economy.

SCHWARTZ: I hope so. You’re talking about these businesses that are holding money.

JESSE: Right, the idea of holding money, the perception that the recovery is fragile, and people are a little more cautious on many levels, tends against that. But I do see that money is more available for projects, no question.

ALEXANDER: It’s like anything else. There’s going to be imprudent developers, imprudent business operators, and certainly imprudent lenders. There’s some of that — people who’ve gotten a little more excited than they should be, but the recession did cull the herd of a lot of those imprudent business actors. So one would hope that people operating today are a little more responsible than the overall industry of eight years ago. We are seeing new investment vehicles come into Wisconsin and the Madison market, which is a great thing. We had some larger national banks receive Wisconsin. Bank of America is a good example, but our own new downtown housing project is being financed by FirstMerit Bank …

SCHWARTZ: Out of Ohio.

ALEXANDER: Out of Ohio. So that’s exciting. They moved from Illinois into Wisconsin, and they are a very successful institution because they were conservative and made the right bets over the last decade. So there’s opportunity there. As long as you don’t have one stupid partner making another stupid partner, you’re going to end up with a successful project.

(Continued)

VANDEN PLAS: Based on your experience in board meetings, are bankers aware of this?

SCHWARTZ: Yes, well-run banks are.

HUTTER: The culling that Joe talked about didn’t just occur in the real estate development market. Obviously, it occurred in the financial market and the banking department and in the banking area. And, presumably, more experienced players remain both in development and in lending who have some recollection of what just happened over the last six or seven years. There are always going to be outliers, people that are going to be too aggressive, but that’s part of the market cycle, right? Those people either make it or they wash out. The slow-and-steady approach is typically the one that works the best.

We’ve seen the best packages for financing and rates that we’ve seen in seven years. The one thing, interestingly, that we have not seen change a whole lot is the equity requirements. They have loosened a bit, from as much as 65% to 70% loan-to-value to closer to 80% now. But that’s on a really, really incredible project. We’re not seeing 85% or 90%. That gives me some comfort knowing that banks may not be moving too quickly to overleverage projects that may not, with proper underwriting, sustain those types of loan packages. As far as the availability of funds for good projects under good terms over longer periods of time, for more predictability, we’re very happy.

Public versus private

VANDEN PLAS: Ron mentioned UW-Madison projects. What do you see in terms of the mix of public and private projects over the next couple years?

ALEXANDER: Public carried us for a while, and that’s going to change. Government budgets are tight, and in Madison we’re lucky that our downtown is really enjoying a renaissance. We’ve got some great tech companies, new and growing. Those folks want to live downtown. I think the apartment market, as it stands right now, is supported. I would expect it to taper off a little bit, but a good project in the right location is always going to be a good project. I would expect commercial office to have, not a huge resurgence downtown, but something of one. As we mentioned, our tenants have grown back to the size they were at pre-recession, and as they need to grow some more, I expect the deck chairs to be shuffled a little bit.

HUTTER: People like to work near where they live. That’s an adage. As the concentration of working folks moves around the Madison area, residential and mixed use is going to follow that. Even as the apartment boom in downtown Madison might taper off, there’s still, based on some of the growth companies that are on the perimeter of Madison, going to be great opportunities for housing. In some areas around Greater Madison, there’s still an incredible dearth of affordable housing and apartments. We have to remember that we’re not just building for the CEO and upper management-level folks with high-rise condos on the Square. We have to think about where our working families with three kids will live. If they are not in the housing market, they must have an alternative.

Public has certainly carried us over the last four to five years, but I see the public spending in the next couple of years not necessarily going down, but private finding very new and unique ways to work with public. There are different communities around the United States that have public-private partnerships that are being created on roads and community developments that haven’t necessarily existed before. It’s going to be interesting to see how the public and private joint ventures might arise over the next 10 years.

BECHER: The public-private partnerships have mainly been transportation and horizontal construction. There are a couple examples in the country on vertical construction. Canada is big into public-private partnerships — same with Europe — and there’s going to be something happening stateside, but I just don’t know what it’s going to look like.

The amount of public work is going to necessarily go down. There’s going to be more private work. Talking to the architects and engineers, they would say they’ve gotten more private work on their books right now than they’ve had for a long time. That’s one of the signs I look for, because that’s telling me six to 12 months [out] what I am going to be building. Going forward, private is probably going to play a bigger role in growth.

Office rebound

VANDEN PLAS: I want to go around the table one final time, and just for this question: Are we likely to see more approaches with regard to office development like the Constellation, where they have mostly residential and a modest amount of retail and commercial in order to add more commercial office space that way, or do you think we’ll go back to a period of more intense new office construction like we’ve seen in the past?

ALEXANDER: You’re going to see modest office construction. We continue to see multifamily, certainly. Very frequently multifamily is mixed use where you’ll have apartments above and a floor or two of retail and commercial below. I don’t think any one project there is an anomaly, but yeah, you’ll see office come back a little bit. In downtown Madison, you’re going to see some more [privately owned] hotels. The strange thing is, it used to be a really bad word, it’s still sort of a bad word, but for the right project on a small scale, you could start to see select condominium projects going forward because there’s no inventory. There needs to be some supply there.

HUTTER: Projects that mix residential and retail and commercial are typically very location-driven. If you’re looking at more urban, downtown Madison, the answer is yes. We’ve moved away from the idea that you live far away, hop in your car, drive 45 minutes to work, and drive back. That type of commute is still obviously done a lot, but there’s a new generation that likes to have access to immediate information, lives on their cell phones, and loves to live downtown. They love to live in the areas where they can get up in the morning and go to work.

In less urban areas, there’s still the concept of the village, where there’s an area where the market is, and there’s an area where people go to do different things, and housing is in a separate area and businesses might be more concentrated. It really depends on where you own land and where you’re developing as to whether that’s going to be a trend. As far as downtown Madison, I would have to agree that idea is a good one, and it’s probably going to continue.

JESSE: With so many things, Madison tends to lead, and where you have the downtown, the larger downtown area, that mixed use will continue to be the model, the primary model going forward, and it’ll become more traditional in the outlying areas.

(Continued)

Where Have All the Workers Gone?

Builders and subcontractors are still trying to rebuild the pipeline of tradesmen and other laborers that was decimated by the recession of 2008, but they have caught a bit of a break. The modest growth that has occurred since the economy stopped contracting means they have not been overwhelmed, but in losing long-term employees and struggling to attract younger ones, the industry isn’t out of the woods.

“It’s a problem that’s been simmering for a while, and the way our society is, it’s a problem that’s going to continue on for a long time,” acknowledged Vern Jesse, an attorney with Murphy Desmond. “I don’t know how we educate, and I don’t mean classroom educate, but educate younger people about the opportunities that are available for them in the trades, the good-paying jobs with benefits.”

Even with plentiful apprenticeship opportunities that expose young people to the trades, the same “dumb, dirty, and dangerous” perception that bedevils manufacturers also impacts builders. This perception exists despite an average wage of $53,400 for construction workers, which is 25% more than their private-sector counterparts.

As a result, builders and contractors are choosing their projects more carefully and trying to make do with the people they have. “There are areas where you’ll put on a subcontractor and you can try to encourage them to be on the job and get the work done, but they don’t have the resources, they can’t find them, and they’re not going to be able to get them,” says Ron Becher, president of JP Cullen.

Returning veterans are a potential source of quality labor, but they are sometimes overlooked. “They’re used to getting up early in the morning; they’re used to working long days,” noted Brad Hutter, president and CEO of MIG Commercial Real Estate. “They stick to a job. They’ve got a lot of organizational skills that they’ve learned in the military.”

Still, if the economy starts growing at a more robust pace and the pipeline of projects overwhelms the pipeline of available labor, builders will be in a pinch. “Down the road, if the economy really took off and there was a lot of extra construction, yeah, there’s going to be a problem,” Becher admits. “If you look at just public work, Daily Reporter shows there’s been a couple projects that had no bidders on them. Just a couple years ago, there would have been five or 10 bidders.”

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