Deal or No Deal?
CCIMs share tactics for winning in today’s challenging market.
What's a transaction broker to do? In 2008, commercial real estate deals were down 71 percent from 2007, according to Jones Lang LaSalle. Total 2008 volume was only $126 billion, far below 2007's market peak of $437 billion.
"[This] has been a tough year for everyone. Many good deals fell apart, over new financing conditions, lower than expected tenant occupancy, and lower net operating income," says Paul Lepine, CCIM, an associate with Re/Max Partners in Fort Lauderdale, Fla.
But as a 2008 year-end e-mail survey of commercial real estate professionals indicates, no one is giving up. In fact, most CCIMs who responded are working harder than ever. "We are working on some smaller deals, focusing on sellers with clear motivation," says Richard G. Knutson, CCIM, managing partner of Premier Apartment Advisors in Alameda, Calif.
"There's a lot of hand holding right now as people's financial lives are being turned upside down," says Brian Jinings, CCIM, a retail specialist with Grubb & Ellis/BRE Commercial in San Diego. "My days are longer, and I try to communicate with clients … with phone calls or face-to-face discussions. As real estate advisers, our role is more important now than when the market was hot."
Of course clients are not the only ones feeling the pain, as many brokers have invested in properties themselves. But instead of running scared, CCIMs see opportunity in the coming months. "Personally I am rewriting my business plan for 2009 to incorporate the industries that I know are still growing, expanding, and in need of space to lease or buy," says Salvatore DiFranco, CCIM, managing principal of Cresa Partners in Cary, N.C.
"Adversity breeds opportunity," says Jim Tucker, CCIM, managing director of Sperry Van Ness in Richmond, Va. "Cautious behavior keeps downward pressure on markets, creates no value for investors, and most importantly gates your ability to catalyze wealth creation," he says. "History clearly tells us … the more severe the downturn, the greater the opportunities … and more lasting and substantial wealth is created."
But in order to make money in a down market, you have to figure out how. The first step is realizing that a new industry paradigm is at work. To make successful deals in today's market, capitalization rates and pro forma numbers take a back seat to cash-on-cash returns and accurate pricing. In addition, a market dichotomy has taken hold:
An increase in distressed properties may mean an uptick in deals this year, but many property owners still are looking for ways to hold tight through the storm. The shakeout in commercial real estate is far from over.
National Capitalization Rates
Average Overall Cap Rate (%)
Change from Last Quarter
Average Change Over Next 6 Months (in bps)
|Strip shopping center
Source: PricewaterhouseCoopers 4Q08 Korpacz Real Estate Investor Survey
Cash Flow Is King
Financing is the biggest stumbling block in the market today: "the combined cost of equity and debt plus the difficulty in obtaining both," explains Edward Craine, CCIM, chief executive officer of Smith-Craine Finance in San Francisco.
"Capital is scarce, scared, or patient," says Ira Bergstein, chief financial officer of Palisades Financial in Fort Lee, N.J. As a result, property investors who used to quote cap rates now are examining cash flow.
"My clients are only looking at return on investment or cash on cash," says W. Darrow Fiedler, CCIM, CRS, GRI, director and consultant for Keller Williams Realty in Torrance, Calif. "Cash flow is king. Equity and appreciation are secondary at best and not in play."
Joseph Springsteen, CCIM, portfolio manager for RCH Capital in St. Petersburg, Fla., agrees. As distressed property buyers, "the real question to us is whether the property has positive cash flowing with some prospect of maintaining current tenancy levels."
Even in healthy markets, investors are looking beyond cap rates. "Oklahoma City has a market that is probably stronger than most," says Judy J. Hatfield, CCIM, a principal at Equity Realty Investments in Norman, Okla. "But investors are paying more attention to the quality of the tenants and the actual value of the land instead of just cap rates when pricing their investments for purchase."
Cap rates "allow investors to make 'apples to apples' comparisons since debt and risk are disregarded," says Mark A. Berezin, CCIM, president of Infinity Real Estate Group in Holyoke, Mass. "However, the strength of the cap rate as a method to judge value is also its inherent weakness."
Commercial real estate professionals sometimes quote cap rates the way residential real estate agents use price per square foot. "It assumes that all real estate is the same, like a commodity," Lepine says. "I've seen a coffee retailer, cell phone retailer, and check cashing store as tenants in a 4,000-square-foot mini center with five-year leases and above-market rents priced at the same cap rate as a national NNN drugstore chain with AAA credit and 60-year history of earnings growth. Investors who bought these kinds of deals based on low cap rates are now finding the coffee shop is gone and the other tenants want a rent reduction or left in the middle of the night."
In this market, an internal rate of return is a much better determinant of value, Jinings says. "The costs of filling vacancies and keeping current tenants — and subsequent effects to cash flow — must all be considered when purchasing property in a declining market. With financing being so difficult and potentially expensive, a cash-on-cash return is a better method to determine property value at initial ownership."
To be sure, investors still are considering cap rates, but in a more-traditional sense — as a measure of risk they are willing to take in this market. "Most investors, like banks, are taking a very different approach to underwriting properties," Jinings says. "Eighteen months ago, investors were comfortable with pro forma rents and anticipated rent increases over the hold period. Vacancies and lease rollovers were seen as a great opportunity to add value. These same characteristics are now seen as a liability."
Indeed, the realities of a contracting economy are a big risk factor. The 533,000 jobs lost in November 2008 — the largest drop since December 1974 — leaves "investors nervously waiting for the 'lag effect' to further upset both fundamentals and values in 2009," according to the Pricewaterhouse Coopers 4Q08 Korpacz Real Estate Investor Survey. It cites the large drop in initial-year market-rent change rate assumptions as a sign of investor anxiety. In 3Q08, "the average for this key indicator has declined 84 basis points. On a yearly basis, it has dropped an astounding 175 basis points."
Price It Right
These concerns are reconfiguring the investment analysis equation. "It's all about the numbers," says Kent J. Cooper, CCIM, vice president of Coldwell Banker Commercial Sun Land Realty in Indian Harbour Beach, Fla. But what frustrates Cooper and several other brokers around the country is that many brokers still are operating under old assumptions.
To illustrate his point, Cooper refers to an e-mail listing for a fast-food NNN investment. The property is listed at a 6 percent cap rate for $1,965,000, with a net operating income of $117,875. "If you only have a confirmed $117,875 to work with, the maximum loan you can get is $938,507, with a 1.35 debt service coverage ratio. To meet the seller's price, the buyer will need to put down $1,026,493, plus closing costs of $56,310, and loan costs of $18,770, for a total of $1,101,573, of which they will get a cash-on-cash return of $30,560 — 2.77 percent — not likely to happen."
Overpriced properties just create confusion in the market, Cooper continues. "When I talk with a potential seller, I get blown out of the water because the broker down the street agrees to list the property at a ridiculous price," he says. "It's time commercial real estate brokers start educating their clients — and themselves — or they may never have another sale. And worse yet, neither will I."
"Brokers [should] stop taking overpriced listings that will never sell in hopes of getting lucky or beating their clients into price reductions. It's a bad strategy," says John Bogdasarian, CCIM, an agent with PreviewProperties.com in Ann Arbor, Mich. "Simply tell the truth, work hard, and get deals done."
"Less inventory correctly priced is a smarter strategy," Craine says. "More major commercial brokerages are depending on seasoned agents to more carefully analyze an income property's operations prior to accepting the listing so that the seller is better served by realistic pricing. Then the brokerage is able to control marketing costs by avoiding unrealistic pricing."
Eliminating the distraction of overpriced properties may help to jumpstart the slow market, another deal-making roadblock. "It's extremely difficult to mark-to-market when there is no market," says Marty Busekrus, CCIM, an investment sales associate with NAI Rauch Weaver Norfleet Kurtz & Co., in Fort Lauderdale, Fla. "Both sellers and buyers want to see reliable comps and there are so very few it's tough to tell just how big the bid-ask spread really is."
And while the sagging economy may wreak havoc with property fundamentals this year, it also may help to break the transaction log jam. Property owners facing deteriorating conditions are being forced to sell. Nationwide, 4,779 commercial buildings worth $107 billion are in or headed for financial distress, Real Capital Analytics estimates. This is a much higher figure than expected, according to RCA's president, Robert M. White Jr. "The recent spike in distressed properties is expected to lead to a wave of distressed sellers in 2009, resulting in perhaps more deals, but also lower prices," White says.
Busekrus sees investors getting their feet wet through loan-to-own deals, especially those with 2009 and 2010 loan expirations. "A building purchased in 2005 for $10 million with an $8 million loan that expires in 2009 is an excellent target opportunity. With the increased lending requirements, owners may only be able to get a $6 million loan in today's market … and will have to come up with additional equity to support the lower loan to value. Investors who can get a 20 percent return using a B piece or a preferred equity stake in properties they wouldn't mind owning will use that tool to ease back into the property markets."
Springsteen also has seen increased interest in similar deals. "A good number of real estate investors are now considering or in the process of acquiring the underlying mortgages at discounts on current principal balances. This strategy of course is fraught with its own issues and requires some experience to wade through the myriad potential issues including foreclosures and bankruptcies."
But buyers are particular about location and the potential upside. "We are targeting commercial notes to purchase at a discount for infill properties with the ability for future enhancements either through redevelopment, repositioning, or retenanting," says Nicolas L. Miner, CCIM, an associate broker with Eagle Commercial Realty Services AMO in Phoenix.
Lending institutions also are clearing their books of bad loans. "The FDIC took over a bank that had a large stake hold in the Northwest Arkansas market," says Joel Sanders, CCIM, associate broker with Colliers International Real Estate Services in Bentonville, Ark., who specializes in multifamily. "Some of the loans tied to commercial properties were bought at cents on the dollar, which is causing a shake-out in values."
Overall, sellers are becoming more motivated, for obvious reasons. "Many sellers are more distressed than they were 12 months ago and are willing to take a reduction on the reversion of their investment in order to free up cash," Sanders says. "In some instances, sellers with attractive properties have to sell those to keep their more-challenged properties solvent. … Some of the larger developers in Northwest Arkansas have filed bankruptcy, creating more incentive for sellers to work harder to close the bid-ask gap."
Seller financing also is helping to move deals among motivated property owners. "A seller can bring more value to a property by financing the property for the short term," Jinings says. "It increases cash flow and reduces the amount of equity required by a potential buyer." On the more creative side, he says, "Buyers are signing short-term leases, giving them the operating control of the property, fixing the sales price, and allowing more time to secure financing. The owner is relieved from management and has a steady, fixed income."
But buyers are also asking for more, says Chuck Wise, CCIM, senior vice president of Sperry Van Ness Real Estate Services in Carlsbad, Calif. "Capital repairs and replacements are being addressed as a closing condition. Buyers are asking for price concessions, rent guarantees, owner financing, and other financial benefits."
Composition of Property Buyers
Source: Real Capital Analytics
Holding Their Own
Although trophy and other class A properties make good distressed deals, not many are on the market — at least not yet. "Trophy properties are still holding their value," Miner says. "Properties with good fundamentals will not go on the market for sale unless something has occurred … such as the owner's death. [Trophy property] owners have already positioned themselves to ride out the current downturn."
Even well-positioned retail centers are holding their own, Jinings says. "AAA well-located properties are maintaining occupancy and [are seeing] competition from retailers to lease space. Asking cap rates are holding firm as class A owners are not under pressure to sell."
But for other retail properties it's a different story, says John W. Willingham, CCIM, CRB, CRS, president of NCR Sunbelt Business Brokers in Bakersfield, Calif. "Owners still in the denial stage are trying to hold tenants' feet to the fire to maintain their cash flow and value. This strategy will hurt them in the long run and result in vacancies that may be hard to fill in the foreseeable future."
A similar situation exists in Florida. "Investors are studying their tenants a little bit closer and are trying to squeeze expenses as best they can. They are requesting sit-downs with all members of the capital stack to try a team approach. But success is only being seen in projects that were conservatively underwritten more than five years ago," says Satya N. Voleti, CCIM, CIPS, ALC, managing director for Sperry Van Ness in Port Charlotte, Fla.
"To maintain value, landlords are looking to reduce operating costs, like utilities, taxes, turnover costs, and advertising costs," says Robert A. Liebeck, CCIM, an associate broker with MJ Peterson Commercial Real Estate in Amherst, N.Y.
But determining how much it takes to remain solvent is difficult in a market that has not reached bottom. "Finding values in the current market is akin to eating dinner out in a very dark restaurant. You know it is food that has been placed in front of you but you just can't easily define it," says Leigh Budlong, CCIM, president of Beyond Value in Sausalito, Calif. "Longer-term owners are more readily able to reduce their asking rents and have. This is starting in the class A office market so it will force the other class buildings to reduce their rents."
"Most strategies being implemented are geared towards cash flow conservation/protection," says Ricardo Rubiano, CCIM, of Terry Ray Construction in Brownsville, Texas. "The more creditworthy tenants are being offered liberal lease conditions in the short term in exchange for more value-creating conditions in three to five years: Free rent, expense stops, and high dollar tenant improvement allowances today in exchange for a more expensive leasing future as economic conditions improve."
Budlong also recommends staying current with local municipality changes. "Pay attention to the zoning that impacts your property. I've heard from multiple property owners that use permits are getting more difficult to get. … If zoning is in conflict to the current use, such as auto repair, you'll have to be extra careful to file on time to maintain that right."
Even in healthy markets such as southeastern Texas, owners are looking for ways to maintain value. "Property maintenance and upkeep is huge in our market," says Lee Y. Wheeler, III, CCIM, associate broker with Foxworth Real Estate Co. in Beaumont, Texas. "Deferred maintenance is the surest way to destroy value and we work with our clients to ensure they stay on top of this issue."
While the current market may have some transaction brokers reaching for antacids — or antidepressants — overall CCIMs seem to be facing the barrage of bad news with calm, reason, and a resolve to turn adversity into opportunity. They clearly understand the challenges of this year. "In the local market, there is at least 12 to 18 months of significant pain to be felt and the same story is true for the national picture," Voleti says. "Unless a miracle occurs, we are in for the long run."
But at the same time, CCIMs recognize the cyclical nature of their business and the need to maintain balance. "I work hard in good times or bad," Knutson says. "I save a bit and build cushion every chance I have. I do a lot to maintain good health and keep stress down. No matter what the economic conditions, life goes on, and we have only one chance to live it to its fullest."
"Supply and demand rules commercial real estate," Lepine says. "The cycle goes on."