Peter Pays Paul

With so much negativity in the news there is a bright spot and an opportunity for commercial real estate brokers and lenders to market to doctors. This niche seems to still be buying.

While office building transactions have fallen off a cliff in recent months, one bright spot many industry analysts point to is the medical office building market, where sales typically range from $10 million to $30 million. According to the latest data from Real Capital Analytics, sales of medical office properties totaled $3.3 billion in the first nine months of 2008, a 13% drop compared with the same period a year earlier. But that dip pales in comparison to the 62% dive in property sales for the entire office market in the third quarter.

Medical Office Sector Bucks The Cycle.

The landlord of the office space leased to Washington Mutual in Pleasanton may be without lease payments when JPMorgan/WaMu leaves the space.

This is but the beginning of the tumult that commercial real estate may feel as jobs are lost and companies vacate their space.

Washington Mutual’s departure from Pleasanton could do more than eliminate 1,200 jobs and erode the local economy and office market: The exit could leave the failed thrift’s landlord in the lurch without rental payments.

Why? Washington Mutual was placed into receivership by the Federal Deposit Insurance Corp. Under the terms of the deal whereby JPMorgan Chase obtained Washington Mutual’s assets through the FDIC receivership, JPMorgan can decide to cease making rental payments when WaMu vacates the five-building complex at the corner of Johnson and Franklin drives in Pleasanton.

WaMu’s failure may empty offices – ContraCostaTimes.com.

The AP is reporting today that California’s jobless numbers jumped to 8.2% this month, a 14 year high.

Subprime’s Impact

Much of the unemployment is related to the collapse of the subprime industry and the ensuing fall of the housing market in California. Countrywide, IndyMac Bank, and other now defunct lenders have gone out of business throughout the state, leaving their workforce unemployed. Locally Diablo Funding closed in October of 2007 leaving 650 mortgage consultants without a home.

The Contra Costa Times is reporting that WaMu/JPMorgan Chase is laying off 1,600 Bay Area workers. The East Bay cut almost 3,000 jobs in Ocotober, bringing the annual total to 22,000 so far in 2008.

A number of the nationwide home builders have been forced to layoff their work force. The construction trades have been dramatically impacted as companies are hesitant to spend money on structures they may not need if consumer demand continues to decrease.

Unemployment Fund Depleted

On top of rising unemployment the AP is reporting that California’s unemployment fund is almost insolvent.

The state’s unemployment insurance fund is expected to have a deficit of $2.4 billion at the end of 2009, forcing it to borrow from the federal government for only the second time since the program was established in the 1930s.

Commercial Real Estate Stress

The unemployment numbers can negatively impact commercial real estate in a number of ways.

1. Vacancy rates may creep up. When companies downsize they need less space. Expect to see rising vacancies in the office and retail sector. The sector least likely to be affect is multifamily, because people still need a place to live and will sacrifice conveniences before they give up their apartment.
2. Rental rates may decline. The basic tenets of supply and demand impact commercial real estate as well. A larger supply of vacant space provides tenants more bargaining power to get rent concessions or to ask for lower rental rates. If the cost of owning a home drops to a level that compares with renting, multifamily rental rates may decrease.
3. Consumer spending is decreasing and will continue to go down. Those without jobs tend to spend less money. (Thank you Captain Obvious.) This hurts both retail stores and service companies. My barber told me that men in lean times will space their haircuts farther apart than during years of plenty. Women will paint their own nails, men may mow their own yard, and Grandma may babysit rather than the au pair.
4. Capitalization rates will rise to their historical averages. Investors will want to be compensated for the added vacancy risk and potential lower income from rent. This compensation will come in the form of higher cap rates. As well, interest rates are likely to rise over the long run due to the affects of inflation and investors will require higher cap rates to cover this costs.
5. Values will decline as capitalization rates rise. Value and cap rates are inversely related. When one rises the other falls.

All of these things are signals that commercial real estate will go through a cyclical downturn. There will be a period of decline as households, banks, and nations deleverage.

Opportunity Knocks

All this news does not mean that commercial real estate is in a death spiral. Quite the contrary. The darkest of night comes before the dawn.

I believe that now smart investors will begin to reenter the market. Not the speculators, that were looking for a quick buck and were hoping for appreciation.

Property values will actually make sense down here on planet earth with real numbers and real calculations. The mythical world of the last 5 years will have to be forgotten.

The bubble has burst and a new day is dawning.

Diana Olick outlines some of the issues that are causing jitters in the commercial real estate world.

“As the market is now deteriorating, as vacancy rates are rising and as asking rents are moderating and in some places declining, gaps in cash flows, how much money is the property producing versus what the debt service payments are, that gap is widening in many cases and it’s making it really challenging to meet the debt service coverage payments.”

Fear Gripping Commercial Real Estate—But Question Is Why?.

There are a couple of key points:

# as vacancies are rising, rents are falling – and any commercial loan based on a overly optimistic (added) "pro forma" analysis is in jeopardy of default.

# new non-residential investment in offices, malls and hotels will slow sharply.

As example, in Chicago there are several new buildings just being finished:

Adding to the vacancies, three major developments are due for completion next year, flooding downtown Chicago with another 3.6 million square feet of office space.

But the good news for landlords – and bad news for construction related businesses – is there are "no new office buildings on the horizon for 2010 and only one … planned for 2011." This fits with the Architecture Billings Index released earlier today.

Calculated Risk: More Bad News for Commercial Real Estate.

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.

We are living in rare days. The financial turmoil is on the headline news every night. The U.S. government has decided that it is the savior of the markets. Congress fought over “The Bailout”. The market can’t decide which way it wants to go.

The news is very gloomy.

Weathering the Storm

Much if not the majority of the news it outside of our individual control. The “winds of destruction” are swirling around our heads.

We can’t stop the winds from blowing. But we can keep our heads down.

You can do nothing anything about macroeconomic problems. You can’t buy enough plasma televisions to save the economy. You don’t control the price of the stock market. You can’t force banks to begin lending.

If you focus on the global economy, the number of unemployed, or the weather forecast for January, you are distracted from the items that you can do today to improve your bottom line.

Focus on Things You Can Control

Focus your energy and emotions on daily items within your sphere of control to ensure that you survive these times. Wasting time and emotions on things outside of your control is ultimately unprofitable.

Focus on Your Attitude

Stay positive. Do not be preoccupied with all that you don’t have. Thinking about toys/gadgets/money we don’t have leads to grumpiness. No one likes a grumpy person.

Rather than focus on what you are lacking, focus on what you do have. Be thankful for things like family, friends, a job, a home, and food. Remember there are always people less fortunate than us.

Focus on Being Productive

What activities can you do daily that will impact sales? Is it phone calls, emails, or personal visits? Focus on completing these tasks. Focus on meeting people, generating referrals, and results.

When will you do these activities on a daily basis? Plan the activities that are profitable into your calendar. Block time in order to attain the results necessary. Turn off the phone. Don’t check your email. Stay on point and accomplish your goals. (Even as I write this I am being distracted by something.)

How many [blank] do you have to do to generate the income that you want? If you reach 5 people a day will it generate the income you want? Do you need to phone 10 people a day? If you email 200 people a month will it generate the results you need?

Focus on Adding Value

If you constantly seek to add value as an employee, as a salesman, or as a consultant you will be rewarded for the value you add.

Too often we are myopic and only think that the item we sell adds value. However, we can add value by relaying good information, referring a new customer, or by offering insight. All of these can be done at no cost to our clients, yet it endears them to us. Caution: Don’t expect to get something in return immediately.

What value are bringing to your boss/client? You are only worth the value you add!

Get Back to Work!

It is easy to see that in these coming times, work will win the day. Those that work harder and perform at a higher level will be rewarded.

The “Times of Plenty” are over. Now by the sweat of our brow we will have to generate income.

Don’t let the negativity distract you from production, staying positive, and adding value.