Steady and Stable... Don't chase quick hits...

Unreasonable Expectations?

We received a phone call the other day that got us thinking. The call came in from a former client who was an acquisitions specialist for a developer. He no longer works for the company that he used to work for ---that developer is still trying to liquidate the surplus of units that they overbuilt in 2005-2009. This person is now working for a “value investor fund”. He called us to tell us about his new job and to solicit our help looking for real estate investments. He engaged us in conversation. He is looking for deals--- he is now what we call a “Scout”.

He outlined what his new company’s investment criteria. “We are ready to buy… We will buy Office, Medical Office, or Retail.” “We have a group of investors that are ready to fund.” “We have promised our investors a 20% return…”

Oh really? I reply… I then wonder; why are you wasting your time and ours? If you are looking for 20+% annual returns from commercial real estate you might as well be buying lottery tickets…

Here is why we believe that. Let’s look at a bit of math… Assume you have a million dollars to invest. If you are seeking a 20% compounded rate of return that means that a million dollars invested for five years with no cash flow for the first five years would have to be sold for and net $2.488 million dollars. So in five years the Asset has to appreciate nearly 2.5 times. But that doesn’t even consider the “value add expenses”. Say the subject property is 10,000 square feet. Assume you do cosmetic and tenant improvements that cost $30 per square foot and leasing commissions that cost $5 per square foot. Initial Investment plus improvements are now $1,350,000. To achieve a 20% return in 5 years, the property now has to be sold for $3.359 million.

To us it is difficult if not impossible to imagine a scenario in which a $1 million dollar property will become worth $3.359 million in five years. The income to justify a $3.359 million dollar sales price at a 9% cap rate 5 years from now would be more than $2.51 per square foot per month triple net.

To imagine a scenario like this occurring we’ll have to go through another cycle—money will freely flow, lending restrictions will ease, prices will increase, more money will come in, and things will get out of control again. It has happened before –and probably will happen again --but we doubt this is the likely scenario any time soon.

Scouts are likely to become frustrated and begin to question whether the chance for quick money and high double digit returns will be attainable at all this time. My gray hair and experience in the commercial real estate business leads me to believe it’s probably more reasonable to expect that a combination of extended consumer de-leveraging and ongoing economic funk will temper lending practices and hamstring demand for years to come. Financial reform will likely bring more restrictions on deal making too. The speculative bubble has burst and very few dollars are going to be made in “distressed real estate” in the short term.

We wish all investors happy hunting and there certainly may be one-off opportunities in the distressed market… We suspect that real estate investors will be better served to stop looking for the distressed quick trading hits. We’re just not going back to the “crazy good old days of 2005” anytime soon. At this point of the real estate cycle we believe that most investors should be focusing on building good core portfolios of well-leased income producing properties, grounded in good fundamentals. Investors should focus on achieving year-in, year out returns in the high single digits where annualized real estate returns historically perform. If values escalate again, these properties will almost certainly jump ahead of the curve so you’ll be in a great position to sell out. That’s why the top properties in the best markets make sense.

People can try to play the yo-yo game of finding rare jewels. But let’s face it--right now the economy and lenders just won’t cooperate. This time around we believe that conventional wisdom may take a lot longer to play out. Steady 8% returns not quick 20% returns is the more likely bet!

If we can be of service reviewing evaluating or finding commercial investment real estate or if you would like to continue the debate over which type of commercial real estate will achieve the best performance please call Jim Gray or Nahz Anvary (916) 375-1500 or at jim&nahz@ctbt.com.

Impact of Distress on Class A Office Valuations

We saw a question posted on a commercial real estate web site inquiring about pricing differences and impacts that Distressed Real Estate is having on valuing Class A Properties. Here is the exact question that was posted on Loopnet. "How are brokers valuing class A properties with so many distressed properties thrown into the mix?"

Here are our thoughts:

The performing "Class A Market" is different than and priced differently than the "Distressed Market".

Recommending a value or proposed sales price takes a disciplined approach, comparing market trends and market demand. Our job as investment brokers is to be able to thoroughly evaluate the property-- including recent comparable sales, an evaluation of income and expenses to determine net operating income, replacement cost, and competitive positioning within the market. In addition understanding the motivations of the Seller, macro conditions in the marketplace, and financing costs and availability, also need thorough consideration today.
In our opinion, there are two distinct and different markets today. Class A properties, those that are stabilized with good tenants and good income, are scarce and are trading at surprisingly low cap rates. Distressed properties -- with income that won't support the debt service, or properties that are unfinished, or poorly performing, in areas with little demand, are being sought by a different category of Buyer. (The property with a "story" that was built or bought at the top of the market.) Distressed vs. Class A Institutional are really different markets and should be and are priced differently.

Class A doesn't just mean "expensive finishes" it means strong demand. In the current market environment, the best income-producing properties—those distinguished by superior quality of construction and the right location are likely to hold their value, keep their tenants and appreciate sooner and more than others. Early in this recession, pricing correction affected all properties, including those with the strongest operating performance and, in the case of new developments, the potential for such performance. But now it is back to fundamental evaluation and underwriting. Location, rent roll analysis, expense benchmarking, strong management and the like makes a real difference.

The relative attractiveness of good buildings to tenants and investors should allow them to stay ahead of the rest even in the challenging years ahead; their values have hopefully bottomed out as the broader market continues to find the bottom. Anecdotal evidence suggests that cap rates on scarce Class A properties with real income and good lease terms are therefore much sought-after assets attracting multiple offers and those cap rates have already come down.

The current cap rate decline starts with that fact that there is more capital (debt and equity) in the market than there is product. That factor alone has pushed values up and cap rates down-- but only for strong assets. Distress Buyers and Distress Prices are different than most well performing Class A properties. Distressed deals get picked over and trade at dramatic discounts to replacement costs; if they trade at all. For many of these deals the owner has no equity and getting quality information and timely decision making is very problematic.

Institutional investors are seeking quality NOI. We are reading reports and hearing about deals in northern California where pricing with cap rates as low as 6+% based for good assets. But if it isn't class A -- and if the lease terms are short and there is any scent of distress or credit quality risk -- or if the likelihood of vacancy and rent-up risk is high --then the cap rate is more like 9% -- and or price per square foot-- well below replacement. That said, there is a great deal of anxiety out there as to how far cap rates have fallen and does it make a risk adjusted sense for them to stay low? The current imbalance of available high quality class A properties and the amount of capital seeking to invest in them has created what a number of analysts and market participants call a "scarcity premium." We believe that the distressed properties that are coming to market are those with little hope of value recovery for the foreseeable future (more than three years). These are two distinct markets -- priced differently for different categories of buyers.

If you have a question that is more specific to a particular property or market - or if we can help you assess the value of your asset -- Class A or Distressed -- or something in between, feel free to contact us. We promise you professional and friendly service. jgray@ctbt.com or nanvary@ctbt.com

Lots of Options --Office Buildings For Sale Sacramento

Office Buildings For Sale in the Sacramento Valley—What Does That Really Mean?
Sifting through Lots of Opportunites...

So you are looking for an office building to buy in the Sacramento area? Or you are thinking about investing in a commercial/office property in the Sacramento area? Well you have plenty to choose from – but you need to refine your search if you want to locate what you really want and you want it to meet your business and investment needs. Office properties are known as one of the four core product types of commercial real estate. Office properties vary greatly in their configuration, style, utility, and economic performance. The “office market” is comprised of many distinct property types. These include modern skyscrapers, medical office, office condos, classes A, B& C, single tenant and multi-tenant, offices for the owner user and offices that are well managed investment properties. There is institutional quality and there are mom and pop offices. Sometimes offices are mixed use with residential or with retail, and there are offices in warehouses and within flex buildings. There are various submarkets and plenty of features that differentiate. Being able to understand these variables and their unique attributes requires a professional focus and asking the right questions.

It is the first of the month and Commercial Brokerage Firms are sending out their “availability lists”. When this occurs, it means that the research staff and the administrative staff are working closely with the Brokers to make sure that an inventory of available property is updated and distributed. When this task is performed by the various offices it also means that the information to the commercial databases such as LoopNet or Costar are also updated. But consistent and uniform information it is not! We thought it would be interesting to review the office market and share some of the findings from our analysis of this imperfect market information.

Here is an effort to describe the current inventory of “office properties” that are “actively on the market”. There are 580 office properties currently offered for sale in the Sacramento Valley. They range in price from $135,000 to $26,500,000. Only 12.5% of the office properties have a quoted cap rate—the other 87.5% are being offered to owner users --or the investment attributes haven’t been provided for their office offering.

To help get our arms around the market we did a few searches in LoopNet to check in on market conditions. The searches included the counties of Sacramento, Placer, El Dorado, Yolo, and Solano. We then looked at the information in these offerings and have the following observations to share:

The first search was for “office properties” less than $1 million dollars. There are 209 separate properties on the market. They range from Victorian houses modified for commercial use to small office condo units. Only 11 of those properties reported a cap rate- ranging from 4% to 9.10%. 198 of the offerings are trying to attract the owner user. Sizes ranged from 384 to 9,600 square feet. Prices varied from $135,000 to $999,999 and from $104 all the way up to $962 per square foot.

The second search was amongst office properties from $1 million to $10,000,000. There are 355 office buildings on the market in that price range. In this category there are properties from $1 million to $9,815,000 on the market. Sizes in this price range from 2,435 to 59,616 square feet and prices per square foot range from $94 to $425 per square foot. Of these offerings, only 55 properties quote a cap rate –ranging from 4.12% to 9.08%. Three hundred of these offerings have no stated income and expenses and are not being offered as an investment.

The third search was for office properties being offered for sale at $10,000,000 or more. In this price category, there were 16 properties on the market. From $10,454,000 to $26,500,000 with more than half of these offerings being “un-priced” and only 6 of these have a quoted cap rate –from 6% to 7.6%. Sizes in these high price offerings range from 34,848 to 153,879 square feet.

There is a lot of inventory; more than 500 buildings being offered to users or being offered without stabilized income --but not a lot of office investment inventory on the market. However, it is worth noting that there are now more than 30 office buildings being offered for sale with cap rates higher than 7%.

If we can assist you with your search for an office for your business or an office as an investment please contact us to see if we can be of service and bring professionalism and value as you sift through and consider available options. If you have questions or comments about this post or if we can assist you with your commercial and investment real estate needs please call Jim Gray at (916) 617-4255 or Nahz Anvary at (916) 617-4257.