Market analysis Investment Analysis

A Tale of Two Markets

For better or worse, investors confront these trying times.

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us ….”
—Charles Dickens

The comments of commercial real estate investors from an e-mail survey of investment habits recall the opening of Charles Dickens’ A Tale of Two Cities. It is the best of times if you are a cash-rich investor eyeing some of the greatest buying opportunities of the century. And it is the worst of times if you are a building owner experiencing 75 percent vacancy and a loan coming due in six months. It is the age of wisdom if, before making acquisitions, you evaluate property yields, determine achievable debt amounts, and plan your exit strategy. But it is the age of foolishness if you buy just because you can get a property for 30 cents on a dollar. It is the epoch of belief: Everyone has faith the market will return — maybe in two years, five years, 10 years? But it is also the epoch of incredulity: Ask any seller reviewing offers. Investors have everything before them — buying opportunities well below replacement costs in prime locations. But those with no cash or financing —“We have nothing before us.”

What registers from this unscientific, anecdotal roundup of current investor habits is a tale of two markets simultaneously occurring: Investors with cash and investors without cash. No surprise here — the cash-rich are large institutional investors for the most part. But some smaller investors also are looking for ways to stay in the market, although many are just “hunkering down,” trying to hold on to their assets in the face of mounting vacancies, stagnant leasing activity, and looming loan payments. The one thing everyone seems to agree on? This sorting-out of the commercial real estate market could take a while.

The Best of Times

Despite the opportunities in some markets, few are rushing in to scoop up properties right this minute — not even investors sitting on piles of accumulated cash. “We are being cautious with our equity dollars,” says Michael Broadfoot, CCIM, of Inland Real Estate Group, a public, non-traded real estate investment trust in Oak Brook, Ill. Given the improving economy, “Over the next six to 12 months property values may lag projections for occupancy and rent increases, allowing opportunistic acquisitions,” he says. However, he adds that management and leasing teams must “outperform the market perception for the assets to realize the projected returns.” In other words, the upside is in the follow-through.

Others are buying but not before they evaluate the opportunities carefully. “Our goal is cautious expansion over the next five years. We have steadily increased our holdings in 2008 and 2009 with expectations of the same this year,” says Jacqueline Ross, president of Investment Strategies in Solana Beach, Calif. “The trick is to structure acquisitions in such a way that they can adequately sustain themselves.”

“Our advice is take cautious but reasonable risks,” says Allen C. McDonald, CCIM, of Baker Storey McDonald Properties in Nashville, Tenn. “In 2009 we purchased three assets and will at least equal or double that this year.”

In just about all cases, potential property buyers are taking their time, seriously evaluating location, tenancy, cash flow, exit strategy, and other factors. Most investors see no reason to jump in unless the deal makes sense on several different levels. “This market is like a creek or river where the water is low,” says Samuel S. Fung, CCIM, a principal with Oregon Commercial in Medford, Ore. “All kinds of debris are exposed and one can examine them.”

If any problems are uncovered, “Don’t move forward,” says Beau Beery, CCIM, director of commercial brokerage and asset management for AMJ of Gainesville, Fla. “There are too many other good investments out there right now to take a chance.”

The lack of urgency is coupled with a larger amount of quality product in some markets. “Now is a great time to go shopping for properties,” says George T. McCutchen, III, CCIM, of Grubb & Ellis/Wilson Kibler in Columbia, S.C. “It seems easier to get better buildings now that sellers have become more reasonable or motivated. You may find something you like, you may not find the right one, but it’s fun to be looking now.”

The Age of Acquisition

What are investors buying? “The favored real estate asset over the past 12 to 18 months is still apartment complexes,” says Rene Nelson, CCIM, a principal broker with PacWest Commercial Real Estate in Eugene, Ore. “There are still buyers who will chase apartments if they are priced correctly using normalized numbers.” But, “Cap rates could increase sharply if there is a substantial increase in interest rates,” she cautions. “This would really hurt the appeal of apartments.”

The dearth of new product over the next few years adds to multifamily’s appeal. “Nationwide, we may have five or more years before any major influx of new multifamily deliveries occur,” says John M. Stephenson, CCIM, of JTL Equity Funds/CRES Management in Kansas City, Mo. “To justify the new construction expense, rents will have to be 30 percent or more above current class A rents. Those who own the apartments built from 2000 to 2008 will reap the benefits from leading the market during the lull in new construction, and will be in a perfect place to draft behind escalating rents when new deliveries occur in the distant — possibly very distant — future.”

Retail is another popular asset choice. “Anchored and shadow-anchored community retail centers, away from power and lifestyle centers and enclosed malls, hold great promise for attractive risk-adjusted returns over the next five to eight years,” says Broadfoot, whose company Inland purchased Merrimack Village Center in Merrimack, N.H., for $9.7 million in December 2009.

These days Inland looks more carefully at retail tenant health before committing, Broadfoot adds. “An 80,000-square-foot retail center that was 100 percent occupied upon acquisition in 2006 may now have 40 percent vacancy and cash flow issues due to the single vacancy of a 30,000-sf Circuit City,” he says. That retailer’s default, along with a host of others, “suggests greater caution relative to square-foot concentration of big-box retailers.”

Beery also focuses on well-located retail centers, particularly those that aren’t doing well because of deferred maintenance or “the owner isn’t doing what he should so there are large vacancies.” He, too, closely evaluates tenant strength. “We pay more attention to the types of tenants that are in place. If a retail center is filled with high-end retail clothing or some very specific niche retailers, we are cautious because we know these industries aren’t safe in every market.”

Beery also evaluates the financial stability of every tenant, even to the point of constructing probability models in addition to their pro formas. “You can statistically predict the likelihood of each tenant renewing or making it financially by doing so,” he says.

Low prices and less competition from residential developers have put land back into focus, particularly sites in the path of development. “In my market, residential and commercial development land discounts are substantial. For a three-to-five-year holding period, I think well-located development land represents a great buying opportunity for the younger investor/speculator,” says Leslie L. Brouillard Jr., CCIM, a broker with Coldwell Banker Commercial in Raleigh, N.C.

The Epoch of Belief

Constrained financing is still reining in acquisition fever, but those who lack cash certainly do not lack ideas. Andrew Mittler, CCIM, of Optimal Properties in Morega, Calif., restricts acquisitions to those “where I can either assume existing financing or obtain debt from a selling lender after foreclosure.” Since most of his buys are distressed properties, Mittler’s deals must generate a cash-on-cash return of 15 percent after a year and a 30 percent internal rate of return over a five-year hold period to satisfy his investors. “To derive these numbers we are running pro forma expenses at higher levels than we have actually ever spent to run a property,” Mittler says. “If the property will achieve these goals, it is probably going to be an investment that works for all involved.”

The current lending environment may be a shock for those who have not experienced a down cycle. “The ability to raise equity is a forgotten art and understanding how to work with equity will be a new discipline for many,” says McDonald, who buys retail assets that are between $2 million and $10 million that can be financed through limited recourse debt to sponsors. “Cash-on-cash returns must exceed 10 percent and IRR’s must exceed 18 percent with cash flow representing about 50 percent of total deal return. Vacancy is underwritten at 8 to 10 percent with downtime of 8 to 12 months and tenant improvement costs of $20 to $30 psf.”

Winter of Despair

Not every investor is in the position — or mood — to buy. Some have been forced to the sidelines by the credit freeze or other factors.

“We have stopped purchasing commercial real estate. Our primary business was tenant-in-common 1031 exchanges, but that market has almost gone away due to several sponsors filing bankruptcy,” says Linda S. Larabee, CCIM, RPA, director of asset management at Principle Equity Properties in Houston. “Now we’re just doing our best to keep our current assets from going under.”

“As an owner/broker of a six-building office complex, my strategy is to stay the course for the coming three to seven years,” says Howard H. Garrett Jr., CCIM, of Howard Garrett & Co. in Roswell, Ga. “We have been reducing expenditures to the utmost and marketing vacant space through cold calls, listing services, and e-mails. However, unless more new tenants are signed soon, [we] may require that our loan be modified to maintain the property’s integrity.”

“Commercial real estate investing is on hold,” says Michael Murray, an appraiser in Bellevue, Wash. “Not really looking at any opportunities at this time, just eyeing the market trying to figure it out.”

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