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Text Box: Beckner & Associates, Inc.

Text Box: Beckner & Associates, Inc.

     
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8409 Pflumm Cir.
Lenexa, KS 66215

(913) 541-4041
(913) 541-0803 Fax

Commercial Real Estate: Where is it going?


Commercial real estate has been in a stagnant condition for the last year.  The public has been told repeatedly that the market is falling and they should expect to buy or lease at bargain basement prices.  But, owners on the other hand see little reason to reduce the lease and sale price on buildings that have stable cash flows.  As a result the market has been waiting for the shoe to drop.  Who is right?  Will there be a blood bath with values and prices dropping drastically or will the market return to its position before the economic melt-down?  In this article I hope to address the current situation and predict the future.  Not an easy project but one about which all brokers, developers, tenants and investors must be concerned.

 

In addressing the current and future conditions, the market must be viewed in light of leasing and sales separately.  Obviously, the two interact but the interaction is better understood if first viewed separately.  In addition, the market is different in each city and each property type.  I will not attempt to cover the entire spectrum of commercial real estate but focus on the office market in a typical market.  Little attention will be paid to the most severely impacted markets such as Las Vegas.

 

LEASING

The leasing market has been very weak.  This is mainly the result of reduced demand as companies attempt to weather the economic tsunami or are like a deer in the headlights as they try to determine the potential impact of the tsunami on their business.  As a result tenants have been very cautious in committing to new leases.  Those most affected by the economic situation may try to terminate or renegotiate their lease or attempt to sublease the space at lower rates.  This results in landlords having to lease space in a market where little demand exists and vacancy rates are increasing.  The landlord must either attempt to weather the storm and be willing to have increased vacancy while attempting to hold to previous rental rates or he must take the steps necessary to lease space in a weak market.  Such steps may include reduced rental rates, free rent, increased tenant improvement budgets, broker incentives, higher broker commissions, and a willingness to enter into short term leases.  Which path they take depends on their future expectations of the market and their ability to carry the property with reduced cash flow.  Although many landlords in the beginning tried to hold to existing rental rates, most landlords are now doing what is necessary to maintain cash flows.  Due to the impact of lower rental rates on the value of a property most owners are attempting to use concessions to influence brokers and entice potential tenants.  In addition, tenants and owners both see an advantage to short term leases especially at renewal time.  The short term allows the tenant to have time to better ascertain the impact of the economic climate before entering a long term lease.  Similarly, the owner maintains cash flow but has not committed to a long term lease at the lower rate.  But, businesses that are not severely negatively impacted by the economic situation may want to sign a long term lease at the current lower lease rates.

 

SALES

The sales market has also been very weak.  This is particularly true in the investment sales market.  Potential buyers are not willing to purchase properties which may be decreasing in value.  They are attempting to wait until the properties are available at much lower prices and thus with higher returns and less risk.  But owners are often not willing to sell their properties at the reduced price.  They do not accept that their buildings have decreased in value so significantly in such a short time.  They will try to hold onto the property and wait for increased values to return with the economic upswing that everyone predicts.  The issue is can they hold on long enough.  Is there enough cash flow to carry the property?  With increased vacancy and lower rental rates many owners will be forced to sell or face foreclosure.  They will move from holding on to trying to recoup as much equity as possible.  The pressure on these owners will be intense.  The investor is looking for this owner.  Even owners that can carry the property under the current cash flow will face a significant problem if they need to refinance or extend their current loan.  I will discuss this situation in another section.

 

In general, the owner/user market is currently much stronger than the investor market.  New owner/users that are not significantly adversely affected by the economy will be graced with both a market with lower rental rates and buildings at lower sales prices.  If they are able to obtain financing they may find a good buying opportunity.  Most will qualify for an SBA loan which allows a low down payment.  They also are looking for owners that need to sell at a reduced price or lose their property and any equity they may have.  The owner may need to escape from their current situation which results in a buying opportunity.

 

FINANCING

The financing problems need to be discussed in two different sections.  The first is the state of the appraising process and the second is the loan requirements of banks as a result of government intervention.

 

Appraising

Appraisers have traditionally based their valuations on historical data and the rental rates and sales data of buildings currently on the market.  Due to this, appraisals in stable markets are easier to validate.  But, in unstable markets the historical data may not reliably reflect the current market trend.  In our current environment many appraisers are basing their appraisal more on anticipated trends than on historical data.  Since there has been downward pressure on lease rates and increased vacancy, some appraisers have tended to utilize rates that they anticipate and not the current or historical data.  In the late 1980ís appraisers were in a similar situation and continued to use historical data in a deteriorating market.  This led to higher appraisals than were later justified by the actual market.  Lawsuits were filed against some appraisers by disgruntled buyers who found they had over paid for their recently acquired property.  I believe that as a result of this the appraisal community has tended to be excessively pessimistic about the current value of the properties they are appraising.  It is not uncommon currently for buyers and sellers to agree on a price and the appraisal to be significantly lower than the agreed upon price.  Since an appraisal is supposed to reflect the price that an informed buyer and informed seller would pay in an armís length transaction, the agreed price should predict the value which the appraiser would determine.  This is not the case in many situations currently.

 

Banking

 

Banks have obviously been under significant pressure regarding their commercial real estate portfolio.  Regulators question the relationship between the current value of a property and the value utilized to underwrite the loan.  In response to this banks are requiring lower loan/value ratios based upon lower appraisals.  This is causing havoc for banks and borrowers.  It has become very difficult to obtain financing to purchase a property due the equity requirements now being sought.  Where this is felt the most is with maturing loans that need to be refinanced.  Owners are finding that they face higher equity requirements on properties that are now being appraised at lower values.

 

Developers

 

All the items discussed above have brought development to a standstill.  Developers can not get financing for projects.  The current rents in the market place do not justify the cost of construction.  Although construction companies are in desperate need of projects they can not provide construction services nor materials at prices that can be justified by rents.  As a result projects that have been designed and received building permits are simply not moving ahead.  Thus, there have been significant layoffs in construction, architectural, and engineering companies.

 

THE PERFECT STORM

We are now in a market where owners are facing greater vacancy, lower rents, even more conservative appraisals and higher underwriting standards.  Many owners will have little choice but to sell their properties at significantly reduced prices hoping to escape with some equity.  Many will not be able to sell due to the reluctance of investors to enter the market.  If they do not find a buyer they will have little choice but to give them back to their lender.  The lender does not want the property but the regulators will not let them keep non-performing loans on the books indefinitely.  Thus they will get them back and have to sell them at a greatly reduced price.  The only winners appear to be the investor with money who waits for the good deal.  Current owners with stable positive cash flow and long term financing will also survive the storm but Iím not sure they should be called winners but survivors.

 

THE FUTURE

As the economy revives there will be a resurgence of demand.  This will first ease the vacancy problems.  But, it will quickly cause an escalation in the rental rates that the owner can demand.  Due to the low level of construction and the time inherent in completing a new project I do not expect new product to be available for up to three years after the market starts to turn.  This will further place pressure on vacancy and rental rates.  The market will then have made a full swing.  With rental rated increasing and vacancy decreasing there will be an escalation in property values.  Thus the market will begin to resume its normal growth cycles.

 

WHAT SHOULD I DO?

This obviously depends on your involvement is the industry.  Contractors and architects should place more emphasis on tenant improvements for the near future until the market can support new construction.  Brokers should focus mostly on the sale of distressed property and the lease market.  Investors should wait until they see what looks like a good deal, purchase it and then reap the rewards of future higher rents and lower vacancy.  The current owner should quickly evaluate his position.  If he does not see that he can survive he should sell now if he can find a buyer.  This is mostly dependent on his tenant mix and his loan parameters.  If he does not have to refinance in the next couple of years he should be fine assuming he can maintain positive cash flow or subsidize it adequately.  He will then reap the reward of ownership that he anticipated when he first bought the property.

 
 
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