Market Watch	September 2003

Real Estate From an Enronian Perspective
John Scoblick, Senior Director, Strategis-CRESA

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John’s extensive commercial real estate background includes six years as Vice President and Director with Enron Property Company and Enron Broad-band Services where he completed transactions with an aggregate value of over $325 million. Prior to joining Strategis-CRESA, John had seven years of commercial brokerage and tenant representation experience. The combination of his diverse background and real estate experiences over the past several years gives John a unique view and insight into commercial real estate from a corporations’s perspective.

It was late 1991 when I first started as a contract real estate consultant with Enron’s corporate real estate group. I was hired by its Vice President Kevin McConville to work on brokerage activities. It took only days to realize that Enron’s approach to real estate, like its core businesses, was going to be vastly different than anything I had imagined. For starters, just a few weeks prior to my arrival a synthetic lease for its 1.2 million square foot corporate headquarters building had been executed with a consortium of financial institutions that ultimately resulted in the 40% reduction in cash operating expenses. This synthetic lease transaction was one of the first synthetic leases executed of this magnitude. Three years later, at the expiration of the initial synthetic lease agreement, we evaluated a sale-leaseback alternative but interest rates were such that we once again opted for the synthetic lease structure. (The synthetic lease is a vehicle available to investment grade corporations, which are typically short in term (three to five years) under which the tenant has the rights and responsibilities similar to those of the owner of a property.) The benefits to the tenant include: a rental rate being a function of the corporations borrowing rate, deductibility of interest and depreciation for tax purposes, while treating the associated interest expense as rent for accounting purposes and keeping the asset and associated debt off the balance sheet.

Earlier this year the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation Numbers 45 and 46 that essentially tightened the requirements for the accounting of guarantees, financial statement treatment, structuring, and disclosure necessary for real estate transactions to qualify as a synthetic lease.

For the next nine years of my tenure at Enron I had many opportunities to participate and, in some instances, observe the company’s innovative view and vision of commercial real estate across multiple operating groups and business offerings. While real estate for most of Enron’s operating groups, had never been viewed as core, it was viewed as a critical conduit to facilitate its explosive growth and in recruiting and retaining top talent. The breadth and depth of these experiences were extremely unique in that it was from multiple Enron perspectives as an owner/occupant, investor, tenant, broker, trader, consultant, landlord, energy provider, mechanical systems integrator, central plant owner/operator and visionaries of a national broadband telecom network.

Enron’s real estate portfolio and offerings impacted office buildings, data centers, telecom hotels, ballparks, airplane hangars, sub-stations, CNG (compressed natural gas) fueling stations, industrial buildings, regional malls, coal mines, farmland, communication towers, rights-of –way, hotels, central plants and abandoned residential development sites.

Enron Property Company - a “For Profit” Corporate Real Estate Group?

Enron Property Company was established in 1990, in some respects as an experiment. Its structure was the innovation of its President Mary Wyatt. Enron’s corporate real estate group’s function was very unique in that it was created with some very challenging parameters. The company was divided into two groups: the brokerage services group, which I was a part of, and the facilities side, which handled all property management, architectural, construction services and churn that in some years exceeded 100%. First, the company was required to be a “for profit” operating group and our continued existence was dependent on profitability. We were responsible for generating a profit on a fully loaded cost basis including an allocation of rent, salaries, benefits and other expenses. Secondly, the corporation did not mandate that the Enron operating groups use our brokerage services. They could either do it themselves, choose to use our group on an hourly consulting or commission basis, or use external real estate providers at their discretion. The reasoning was that if they could not receive “best in class” services internally they should not be obligated to use us and over time we would cease to exist and our real estate services would be out-sourced to external providers by default. As a result, we had to sell our services internally and provide exemplary results. Fortunately, we managed to maintain a substantial part of our operating companies’ real estate business.

An unintended consequence of the “for profit” mandate was that, on a limited basis, the brokerage group began prospecting and representing non-Enron entities in their real estate requirements. These included a national law firm, a trading operation and international investors. This success created some interesting reactions both internally and externally in the market place.

During the outsource explosion of the 1990’s our corporation also went through an exhaustive study by a highly regarded consulting firm. As a result of their recommendations, Enron would outsource, to some extent, its mailroom, security, travel, health club, cafeteria and even our internal audit function. What came, as some surprise, was the affirmation of the continuation of the corporate real estate function, which for many corporations, was a logical candidate for outsourcing. Our structure was such that our fiduciary was properly aligned, we had significant talent and resources available and we were generating profits year after year. (We were told that consultants recommended our real estate model to a few other major corporations with little success.)

We did, however, use a number of outside real estate brokers and consultants on a non-exclusive basis generally in circumstances where we were not licensed (including out of state disposition transactions), lacked market knowledge or felt we needed some particular expertise. In my mind the most difficult part for me as a corporate real estate executive was to outsource “trust” to a third party provider. My experience, from that of both a broker and a corporate real estate executive, is that in every transaction there will be at least one situation, if not more, where the financial and strategic interests of the tenant are, at the very least from an appearance perspective, in potential conflict with the financial and personal interests of the outside broker. We experienced it first hand as a “for profit” corporate real estate group. For example, in the mid 1990’s, 1415 Louisiana was on the market for sale and the following year our 200,000 plus square foot lease was expiring at Three Allen Center. After some interesting discussions with our executives as to which groups would be relocated in the event of a purchase, we recommended and received approval to submit a bid for 1415 Louisiana, which was unsuccessful. In that particular situation had we acquired the building the commissions to Enron Property Company would have been approximately 20% of what ultimately was received as a result of the Allen Center renewal.

A look into a few deal structures…

Disaster Recovery Challenge

It was early 1995 and Enron’s lease in downtown Houston was going to expire at the end of the year. Oklahoma City had recently gone through the terrorist attack on its Federal Building and there was a heightened concern of many corporations’ senior executives, security personnel and its real estate departments on what prevention and recovery plans could be initiated in order to minimize business interruption in a similar terrorist event or natural disaster. Enron had previously constructed back up trading stations in Omaha, Nebraska to support trading operations. But we had other critical operations that also required back up. Executive management made a disaster recovery plan the highest priority, with a firm mandate to get it done. In that regard, a meeting was set up with a major developer in Houston and we posed the question as to what inventory was available and at what cost and conditions would they make space available to us in the event of a disaster.

They indicated that they would make available to us roughly 200,000 square feet of space in the lower elevator bank of one building in the Galleria area in return for payment of the operating expenses of $1,400,000 per year. The problem with this proposal was the cost of the option on the space and the fact that it was in only one location. It would work only to the extent that this particular part of town was not subject to the same disaster as our headquarters building and that we needed no more than 200,000 square feet. Additionally, we had to pay the $1,400,000 regardless of whether we ever needed the space. Even if we could strike a similar type transaction at approximately five other geographically diverse locations around the city it would cost us roughly $7,000,000 a year to do so.

Earlier that year we had commenced evaluation of our downtown occupancy needs and had begun discussions with alternative locations and our current landlord at Allen Center, Metropolitan Life. After roughly a year of “challenging” negotiations with Jane Page and others of Met Life and Transwestern’s project leasing team of Randy Strait, Chip Clarke and Phil Arnett, we came to an agreement. As an important part of that lease renewal, Enron was able to secure an option to occupy any non-encumbered space of the Metropolitan’s multi-million square foot, geographically diverse Houston portfolio at pre-agreed to terms and conditions. It was one of those “win-win” transactions that occurs every now and then. From Metropolitan’s perspective the likelihood of such a disaster was remote, it was space that was available for lease, we had agreed that if required to return the space back to its original condition, and the concession was very important in closing the deal which through expansion rights grew to 300,000 square feet. From Enron’s perspective it was important to us in preventing the interruption of our business no matter how remote, the Metropolitan portfolio had properties in multiple Houston sub-markets and our only other alternative was to pay some $7,000,000 a year to purchase that option from multiple owners.

Search for World’s Largest Trading Floor

The growth in Enron’s trading businesses during the 1990’s was phenomenal. The company was continually expanding the volume and number of commodities it traded. One of the challenges, from a real estate perspective, was how to accommodate now only the number of traders but also the communication amongst the traders and trading groups. Locating them all on adjacent floors helped and tearing down all the walls also helped but in the end the 22,000 square foot floor plate was a severely limiting factor. Additionally, from a public relations perspective the importance of Enron’s image was also growing. We had gone from a relatively unknown Houston entity to one that was achieving significant global success and making a major marketing statement was becoming more crucial.

As previously mentioned, we had a significant presence in Allen Center, which was accommodating our growth outside of the headquarters building. While we had purchased some property across the street as insurance in the event that some day our growth would warrant a new building, that discussion was off the table. So how could we possibly provide a strategically superior working environment for our traders and at the same time make a statement about Enron? It occurred to me that a possible alternative, although a bit far fetched, was that part of the huge Allen Center parking garage was being currently utilized by the Metropolitan Racquet Club. The club occupied an enormous footprint including several tennis courts, racquetball courts and workout facilities and we had a pre-existing tenant relationship with the landlord. An extensive study was conducted by the facilities group and determined the undertaking was possible but rejected internally due to economics. At the end of the day there was a premium the corporation was willing to pay for the more productive working environment and to some extent the statement such a marquis facility would make. We just couldn’t make a business case to justify it so the project to create the world’s largest trading floor was scrapped.

“Enron Inside” Commercial Real Estate Energy Services Infrastructure Offering

In late 1995 I was recruited out of the real estate group to be one of the first dozen or so employees to evaluate the opportunities presented as a result of the proposed deregulation of the electricity industry. Within three years the group grew into one of the company’s largest operating groups and received much of the accolades in Enron being named by Sales Marketing and Management Magazine as the number one ranked sales force in the country. Early on the vision was that as deregulation was approved on a state-by -state basis we would become the largest trader of retail electricity. Realizing that the process was going to take some time it was decided that we would focus not only on power and gas commodities but also on the energy infrastructure of large industrial and commercial real estate users. The company began to market multi-year energy outsourcing arrangements whereby Enron Energy Services would have the right to provide energy and energy related improvements to buildings and portfolios of real estate owners. We were well on our way to establishing an “Enron Inside” like statement of energy supply, technology and mechanical efficiency. With that could come purchasing power to the extent it that someday it would become one of the largest procurers of energy related mechanical systems for real estate properties.

Early in the existence of the company Allen Center a multi-million square foot class “A” office development in downtown Houston was listed for sale. It is a marquis development that had peaked a number of substantial real estate entities interest in acquiring it. Enron Energy Services made it known that it would be willing provide additional equity to the bidding parties in exchange for the purchase of the large central plant and the ability to sell energy at predetermined prices to the complex at the time of deregulation. We worked extensively over a short period of time to reach a mutually acceptable agreement but to no avail. At the end of the day an agreement could not be reached and, Trizec Hahn, a competing bidder was awarded the project.
While this particular transaction was never completed it demonstrated a unique opportunity within the commercial real estate market and uncovered a hidden real estate asset. Subsequently a number of energy services contracts were executed with real estate entities including office building and mall owners.

Race for Bandwidth - Real Estate as a Commodity?

In the late 1990’s Enron Broadband Services was created to establish a “first mover” advantage in bandwidth trading. The objective was to light a national fiber network connecting the nations major metropolitan areas and to install equipment to facilitate a bandwidth-trading platform. Enron had been quite successful in the past in the trading of commodities such as gas and power and was bringing to bear on the bandwidth arena that same intellectual capital and systems infrastructure.

During the technology boom there were predictions and expectations by Wall Street analysts and wishful thinkers that the demand for bandwidth would be insatiable. The use of the Internet, computers and video on demand would require tremendous capital investment in fiber and technology in terms of servers and routers in order to connect users. The race was on and for the first time real estate was viewed as not only critical to our success, but core to the business of bandwidth trading. Nationally, telecom related real estate rates spiked. Everything from malls, to department stores to beer distributorships to post offices to bunkers were targeted for redevelopment. It was not uncommon for rates to reach $30, $40 or $50 per square foot in a bidding war atmosphere. Startup companies were offering landlords shares and/or warrants in their companies in exchange for the scarce technology facilities.

Trading of bandwidth was conducted in, what was referred to, as Telecom hotels. These strategic real estate facilities were evaluated from the perspective of security, construction, redundancy, power availability, ceiling height, absence of windows, presence of other users and trading partners located in the facility. It had nothing to do with traditional real estate differentiators such as view, aesthetics, location of employee residences, parking, restaurants, work out facilities, airport access, banks, cafeterias etc.

What is inherent to commodities is its homogeneity, as in the case of gas; for example, each molecule of gas is almost indistinguishable. Real estate facilities, in most instances, are very unique and distinctive even within the same building. Our commodity theory, as it related to the telecom facilities, was based on the premise that since aesthetics and amenities, in the traditional sense, were not a differentiator, once inside the telecom space it would look virtually the same no matter what building you were in anywhere in the country. The rooms would be full of rack space, cabinets and cages with cables connected to the equipment. Taken a step further, while the right to the external real estate would often be based on long-term commitments, the usage and access to the equipment inside the space could be of much shorter duration of months, week, days or even minutes. It could further lend itself to risk management techniques on the real estate portfolio in terms of having long or short positions depending on the nuances of each particular market. In a very mature market you could conceivably know on a day-to-day basis the relative value of your bandwidth real estate book. It was an interesting premise that never became a reality, however. .

Enron Real Estate Risk Management Office Index

Shortly after I resigned from Enron Broadband Services in August 2000 as Director of Real Estate I was approached by a group within Enron for my opinion, reaction and consultation regarding a new real estate risk management product that was under evaluation.

It was certainly an ingenious concept that would allow both building owners and tenants to protect against future market rental rate fluctuations. The various products would provide financial protection against rising and falling rental rates and would not involve the physical space of either the tenant or building owner. It would be strictly a financial relationship.

The structure of the concept, not surprisingly, would be similar to what the natural gas and electricity industry has established in terms of market based indices at certain pricing hubs around the country that are considered to be the true market indicators of price (at least until most recently).

The primary benefit to the office tenant would be the ability to address budgeting needs by being able to lock in a maximum lease rate exposure on future lease renewals. The primary benefit to the building owner would be that they would no longer be restricted to transacting on a physical basis but also could give consideration to transacting on a financial basis.

The major challenge, in my mind, was to find a suitable index that the majority of tenants and building owners could rely on with complete confidence. The indices used for energy commodities are well established, transparent, posted immediately and reflect changes in supply and demand and, most importantly, represent actual prices.

The establishment of a similar index that would be embraced by the real estate industry would be much more difficult to create because real estate, as was previously discussed, is not a commodity. There are different classes of buildings, in different sub-markets within a given city etc. Each transaction’s pricing is unique and you would have to use a true net lease rate to exclude pricing variations due to tenant improvements, free rent, operating expenses and so on. Pricing in real estate leasing transactions is not transparent nor does an independent third party track it. The closest provider of this type of information the real estate industry has been able to develop, to date, are real estate market data firms. However, these firms report quoted rates, not actual rates and their information are historic, not real time and are subject to error. Frankly, I don’t know whether Enron was successful in attracting any customers to the program prior to its well-chronicled and unfortunate demise.

Reflection

To an extent, I had some reluctance in writing this article and revisiting the rise and fall of Enron; it makes one really think of the dramatic impact on the individual’s lives. Much has been chronicled on allegations of impropriety at the top, “whistle blowers”, the bus tours and the terrible personal tragedies, which are far too numerous. What doesn’t get very much attention are the thousands of former Enron, Arthur Andersen, El Paso, Dynegy, Reliant, CenterPoint, Calpine and other Houston company’s current and former employees that are down but not out. These are very bright, driven; resourceful and resilient people who have shaken off this adversity will continue making a difference in our city’s growth. Many of the former employees have found employment or begun their own companies and Houston is probably the best city in the country for aspiring entrepreneurs.

A Few Observations

I do not have a crystal ball as to whether Houston will have a 12.2% office vacancy next year or a 17.1% vacancy, or for that matter any guesstimates of rig count.
I do have a few general real estate industry observations:

• A consequence of these difficult economic times is that once again corporation’s real estate holdings (which for many companies represent 10%-20% of their costs) will receive increased scrutiny as a way to increase cash flow, liquidity and decrease operating expenses.

• Resulting from these real estate portfolio reviews, corporate real estate executives will be asked to realign real estate holdings with its new corporate strategic plan.

• Corporations will require more “strategic” advice from the real estate community that doesn’t necessarily involve “commissionable” transactions.

• There will be an increasing concentration of real estate owned by institutions and real estate investment trusts impacting market conditions.

• The demand from corporations for “turnkey” tenant representation and quality project management services will continue to grow.

• While tenants, landlords and the tenant’s brokers have done well in “making” the current structure of the landlord paying the tenant’s broker work, the trend for corporations to compensate their real estate advisors directly will continue to gain some momentum.

A Few General Market Observations:

• We are “not” totally out of the woods as to financial challenges facing our energy related companies and financial institutions particular those impacted by the state of distressed power assets. There are billions of dollars of non-performing debt nationwide that has yet to be addressed.

• The three most important things about real estate from a landlord’s perspective will be “Credit, Credit, Credit”

• The three most important things about real estate from a credit tenant’s perspective will be “Concession, Concession, Concession”

• As in the past during times like these, there will be some migration of “B” tenants into “A” buildings.

• Mobility will weigh most heavily on location decisions.

• I believe Citgo’s contemplated move to Houston is to some extent a function of the affordability of real estate and quality of life issues but to a much greater extent on the availability of intellectual capital and that there will be more of these skill based relocations.

In the end the “can do” attitude of Houston industry and residents will carry the day. As the often repeated saying goes “never underestimate the heart of a champion”.

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