Case Study: Pull the Plug on a Project with an Uncertain Future?

Alex Kozak was sitting in his Moscow apartment waiting for his colleague, Nikolai Krylov, to join their Zoom call. When his video window popped up, Nikolai announced with a smile, “I have good news!” It had been a while since Alex had gotten any of that. In fact, he’d spent the past several weeks holed up in his apartment because of the global pandemic lockdown, and it had begun to feel as if the world was unraveling around him. “I’ve got a potential buyer,” Nikolai said. He and Alex had been working together for the past six years on the development of a 700,000-square-foot commercial office building in Moscow, which they’d dubbed Eastern Square. Alex was leading the project for his company, the New York–based property firm EPM, and Nikolai represented its local joint venture partner, Krasny Invest, which had traded a prime parcel of land close to the Presnensky district and its expertise in navigating Russian bureaucracy for one-third ownership of the project.1 In late March they’d had to pause work, and Alex had thought they’d be using this virtual meeting to discuss restarting. Selling the development was not on his radar. CASE STUDY CLASSROOM NOTES 1 Experts on business in Russia often recommend that foreigners operating there have a local partner to help manage the unique complexities of the market . “It’s an investment firm based in Kazakhstan, and they’re eager,” Nikolai continued, either ignoring or not noticing Alex’s shocked look. Alex knew that Krasny Invest was reeling from the abrupt halt in the Russian economy, as were so many others, but he’d thought they would stick this project out. The timeline had been extended, of course, but thanks to the strong architecture, engineering, and construction teams they’d assembled, they were only a year away from completion and already had a prime anchor tenant, a U.S. company opening its first Russian office.2 2 Despite increasing sanctions since 2016, thousands of U.S. companies have offices or facilities in Russia . Nikolai explained more of the details. The proposed deal with the Kazakhs would monetize the project’s $100 million of invested equity plus a small profit. This was only a fraction of the more than $475 million in profit that Alex and Nikolai had projected so confidently back in January—a healthy increase from the $200 million in profit expected when the project was first conceived. Of course, as Alex well knew, the past few months had introduced many new risks. What would the Moscow real estate market look like in a year? Would the economy recover that quickly? Would people even be going to their offices? Or would companies shrink their footprints and let people work from home?3 The team had navigated the 2017 slump in the Moscow real estate market. But this crisis was clearly different. 3 According to an April 2020 Gallup poll, 55% of U.S. managers expected to change their remote work policies in the wake of Covid-19 . “I need to process this,” Alex told Nikolai now. “Look, we’re all scrambling,” Nikolai said. “Between you and me, my company needs the liquidity. But given how the world has changed this year—and specifically how the workplace has changed—I think it’s smart to get out now. We might not be able to secure an offer like this again. Talk to Alicia.” Alicia Mendez was a managing director at a London-based insurance company with $150 billion in investments globally, including a 33% stake in Eastern Square. “I need to talk to my bosses, too,” Alex said. “And the construction team.” Alex stared out his apartment window. As an American expat with family roots in Poland, he’d come to love Moscow, and he hated to see so much suffering in this city as well as around the world. He believed this project would be a catalyst for the city’s further growth—and he had put his heart and soul into it. If they sold now, his company and its partners wouldn’t lose money, but he’d have wasted six years of his life. What’s more, he’d forgo his outsize share of the potential profits. Did he really want to start a new project in this economy? We Can See It Through That evening Alex logged in to his last videoconference of the day—this one with Alicia. An influential partner at her firm, she managed a $30 billion real estate portfolio and had always been fully committed to the Eastern Square project. But like everyone else, she was now worried. “Before we talk about Nikolai’s proposal, I want some more info on where things stand with construction,” she said. “We had a two-hour meeting with the foreman earlier today; he and his team are set to restart as soon as they get the green light from the city,” Alex explained. “But they’re understaffed, and new guidelines are restricting the number of people we can have on-site. Their best guess is a year’s delay at a minimum.” “And worst case?” “He mentioned three years.”4 4 Could a longer timeline benefit the project if it meant the complex opened in a stronger economy? Alicia’s eyes widened. She took a breath. “Well, a delay could work in our favor, despite the higher interest costs. It would allow time for the economy to recover, for a vaccine to be developed, for people to return to the office. And the anchor tenant?” “I talked to the COO today, and she said they’re deep in planning revisions but as of now still hoping to move forward with the expansion to Moscow. They might not need the full space though. She threw out the idea of 50% capacity.” Alicia was silent for a moment. Alex waited. “As you know, we play the long game,” she finally said. “Moscow’s commercial office sector has long been underserved, especially at this grade.” That was what had initially sold her on the project. The city had so few quality office buildings that competition over the existing stock was fierce. And Eastern Square was the most significant development in the pipeline through 2025. “The question is, will there still be demand when the market recovers?” Alicia continued. “Right, of course,” Alex said. “That’s hard to predict. There are some financial upsides—falling interest rates, cheaper labor costs—but we need to keep our tenant and also attract others. I think we can still achieve a profit of more than $400 million if we pursue the long game, as you said.” “There may be an opportunity to offer new state-of-the-art features like air filtration and touchless entry,” Alicia replied. “Those could be critical differentiators.5 If you feel strongly, I think I can persuade people here to see this thing through, with a fully baked proposal from you on how we can weather the storm. Things may get worse before they get better.” 5 Health experts have recommended that offices reopen only if they are equipped with protections against spread of the coronavirus . Alex nodded and smiled. “I can do that.” But as soon as he closed the Zoom window, he asked himself, Can I? He couldn’t escape the ominous headlines from cities around the world. If he was having trouble convincing himself, how could he convince others?6 And even more distressing, should he try? 6 Given that his interests aren’t the same as his partners’—he’ll lose less financially if Eastern Square fails—how should Alex weigh their opinions? Past Experience It was close to 2:00 am, and Alex, still awake, called his mentor and former business school professor, Jay Huang, who’d spent his career in real estate development before joining academia. “Are you getting any sleep?” Jay asked. “Some,” Alex lied. “I manage to fit a few hours in between scenario-planning sessions.” Jay knew Moscow well. Right after Russia opened to outside investors, he had bought up land and built numerous high-end properties in the country. He’d left the city soon after the 2008 global financial crisis.7 7 Russia’s economy was hit hard in 2008 when oil prices collapsed and foreign investors withdrew capital from the country. “What are you seeing?” he asked. “Obviously the possible range of outcomes is wide,” Alex said. He explained that assumptions about rent and cost of capital could hold or, if things continued to deteriorate, could fall even further below his initial projections. The vacancy rate in Moscow had already spiked from 0.5% to 7% practically overnight. Alex gave Jay more details about the Kazakh investor’s offer. “Nikolai says they see this as an opportunity to get a trophy asset at a great price. And they’re eager to close the deal soon, which would give Krasny Invest the liquidity it needs. Plus Alicia and I would get a modest return on our investment. The EPM brass wouldn’t be angry, but they wouldn’t be happy either. This was supposed to be our marquee development for 2021. If it turns out I’m selling at a bargain, it would be a bad move.” “What does your boss say?” “He’s super busy with other projects in the EPM portfolio. Honestly, most of my counterparts are in a worse position than I am. Besides, you know how EPM operates. I’m the one on the ground, so it’s my call: Make it work or cut and run.” “If Alicia is willing to stick with you, could you persuade her to buy out Nikolai’s company? Or would EPM?” “Us, no. Not now. Alicia, possibly. But I’m not sure I can navigate this without Nikolai. I suspect that the project has gone as smoothly as it has only because he’s a drinking buddy of half the town.” “I hope you’re not beating yourself up,” Jay said. “These are strange times, to say the least.” “I recognize that this is mostly out of my control, but I’d love to be the person who pulls it off despite the odds. There’s no denying that it would have huge upsides for me, from both a financial and a career perspective.” “And you’re so close to the finish line. This crisis will end. The global economy will recover. Companies will bounce back. The Moscow market will start growing again.8 Even in the aftermath of 2008, I had success with my projects. These things pass.” 8 According to an industry report, the value of commercial real estate transactions in Russia increased by 34% in 2019 to a total of $3.8 billion . “Spoken like a true real estate developer.” Jay laughed. “You’re one of us now.” Start Over from Scratch? Early the next morning, when the sun was barely up, Alex put on a mask and walked from his apartment to the Eastern Square site. A few months earlier these streets had bustled with people. Today the few others he passed were in medical or police uniforms and also had their faces covered. It felt like a dystopian future. Would any city ever operate normally again? Were he and Alicia crazy for thinking that a central-city office project could still succeed? He reached his destination. If Covid-19 had never happened, construction workers would have been arriving, putting on their hard hats, and starting up the cranes and lifters for the day. But all was still. He looked up at the shell of the building and felt a tightness in his chest. He’d lined up a well-capitalized investor, a well-connected local partner, a reliable construction team, a premier location, and a world-class tenant. What seemed like the most promising project of his career was now at risk. This development had been his life for six years, and the thought of giving up on it now was difficult to stomach. Beyond the emotional investment, Alex had real dollars to consider. If he could salvage the project, his company’s share of the investment would be worth millions, whereas a sale now would mean starting this chapter of his career from scratch. Question: Should Alex push the project forward or take the deal? The Experts Respond Bianca Bagnarelli Sheila Botting is the president of Americas professional services at the commercial real estate firm Avison Young. THIS IS A CASE for the bird in the hand. Alex should take the deal with the Kazakh investors and benefit from the value he has created to date. Could he hold off and make more? Potentially. But he could also lose everything. And that’s not a risk worth taking at this stage. In my role at Avison Young, I regularly advise people on decisions like this one. This is a complex international development, and its success is contingent on local planning approvals, construction crews, and tenants requiring new office space—in the middle of a pandemic and an economic downturn. Many moving parts need to come together. In addition, during this work-from-home period, organizations and employees are recognizing that they really don’t need to be in the office every day. Flexible work is rapidly gaining traction, and with the right technology, many people can work anywhere, anytime. Office desks in North America are typically only 50% utilized, and even before the crisis, companies were already questioning their real estate costs. I believe they will continue to reduce and optimize their footprints. Don’t get me wrong: I’m not declaring the office dead. But its role will evolve; workspaces will be hubs of innovation and collaboration where people, cultures, and ideas can mix, not places we go to every day. And flexible work schedules will be a key factor in the war for talent. Of course, every project is unique. And before Alex decides what to do, he needs to complete a risk assessment based on data and financial analytics and also review the deal structure with an appreciation of each partner’s perspective and exit requirements. Then he should consider the macro geopolitical and economic environment, including the shrinking Russian and global economies. In June the World Bank predicted that the latter would contract by 5.2% in 2020. Alex should also investigate the fundamentals of Moscow’s office market: supply, demand, and pricing. As in many cities around the world, the Covid-19 crisis has caused the number of vacancies to rise, which doesn’t bode well for Eastern Square. As Alicia points out, down economies often mean lower development costs. But will labor be available to complete the project? Will materials costs go up? Will the anchor tenant reduce its commitment or drop out? And what about the planning approval process? Could Alex find a replacement for Krasny’s role and equity? Alex needs to quantify these risks and run a sensitivity analysis on the cost and revenue sides. He should also gather data from local real estate brokers who understand market dynamics and how tenants’ needs are evolving. Naturally, Alex is personally motivated to finish this project. But if he takes the deal now, he will most likely be making a shrewd decision to protect the capital of his employer. Rather than a career killer, this could be a career maker. And there will be another opportunity. In real estate there always is. Brian Patterson is the founder of White Star Real Estate, a Central and Eastern Europe–based developer and investor. WHEN MARKET CONDITIONS change dramatically, there is often pressure to sell at the worst time. Rather than pull the plug, Alex should focus on getting more information, evaluating options, and considering available solutions. In high-stakes situations, emotions will often lead you to exit before the door closes. But the door rarely closes completely, and it’s never wise to make underinformed decisions. This case is loosely based on my experience during the 2008 global financial crisis with a similar real estate development in Moscow. It was a different time—and a different crisis—but many of the considerations are the same. The question I faced was “Can I, along with my partners, address the uncertainties the crisis has introduced and find good outcomes for everyone involved?” To answer that question, I did what my mentors have always counseled me to do with decisions during market dislocations: I broke down the big problems into smaller ones, brainstormed solutions with the team, and then considered how practical and feasible they were. We met with our key stakeholders and drilled down to understand the unique problems of each of them. Then, together, we thought about how to help them so that they could stay the course. Our Russian partner needed to monetize his interest so we immediately started seeking a replacement investor. We closed with the new partner six months later, securing our original partner a far higher price than the discounted one that had been offered, as in this case, by a Kazakh firm. During those six months we worked in parallel to solve the other problems we faced. We started with what I saw as the biggest risk: a default on our bank loans and foreclosure. To prevent that, we had to accommodate our anchor tenant’s demands. This incurred a substantial additional cost but a huge potential payout. We then had the “dry powder”—a huge cash flow once the project was completed—to guarantee our contractors large fees and bonuses, payable when rental income started coming in, which would keep them afloat. In effect we shared the profits with the other stakeholders to address their issues. A crisis is no time to be greedy. Alex should follow a similar process. Once he sees a path forward, he can create a compelling narrative that convinces his bosses, Alicia, Nikolai, the contractor, and the tenant that they can navigate from “The world is falling apart” to “We can make this project a success.” That will take time and a lot of effort, of course. Back in 2008 we had dozens of strategy meetings, and Alex will need to do the same. But our approach worked. The market settled. We were able to keep our lessees. And we made four times the profit we had initially projected. I believe that’s what will happen for Alex, too—especially if he’s able to incorporate the state-of-the-art health and safety features that Alicia suggests and position Eastern Square as the office building of the future. Even in an era when more people are working from home, there will always be demand for quality commercial property, especially now that more space is needed to keep employees safe and productive. When you’re in the depths of a crisis and everyone is panicking, it’s best to hold steady until people see the green shoots—the signs of life—again. They will come. HBR’s fictionalized case studies present problems faced by leaders in real companies and offer solutions from experts. This one is based on the Stanford GSB Case Study “White Square: A Perfect Storm in Moscow” (case no. RE140-PDF-ENG ), by Cody Evans, Brian Patterson, and Chris Mahowald.

Case Study: Pull the Plug on a Project with an Uncertain Future?

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