Catch 22 -- Logical Paradox of this Recession and The Recovery

An Economic Catch-22 —A Logical Paradox for Job Growth?

A recent report from the UCLA Anderson Forecast issued June 15th 2010, predicts that the California economy is expected to grow a bit slower than the nation's economy for 2010, and only slightly faster thereafter. This slow growth rate will result in only modest inroads into the state's high unemployment rate.

The report titled “A Homeless Recovery,” concludes that this time around, the economy can’t count on free-spending consumers to boost it along. The report cites today’s “frugal consumers” and describes “If the next year is going to bring exceptional growth, consumers will need to express their optimism in the way that really counts; buying homes and cars. And that is not going to happen if businesses continue to express their pessimism in the way that really counts by not hiring workers.”

In another element of the forecast, the economists predict the recovery will be “rocky” in the commercial real estate sector. “There is just too much debt that has to be worked through”.

The report cites an “Economic Catch-22.” (A Catch-22, coined by the author Joseph Heller in his novel of that same name is a logical paradox wherein a situation exists in which an individual needs something that can only be acquired by not being in that very situation; therefore, the acquisition of this thing becomes logically impossible.) The challenge is that significant reductions in the unemployment rate require real gross domestic product growth in the range of 5% to 6%, compared with normal GDP growth of 3%. As a consequence, consumers concerned about their employment status are reluctant to spend and businesses concerned about growth are reluctant to hire.
UCLA Anderson’s forecast for GDP growth this year is 3.4%, followed by 2.4% in 2011 and 2.8% in 2012, well below the 5% growth of previous recoveries and even a bit below the 3% long-term normal growth. In the California forecast they indicate that the state “will grow slower than the US and a slow recovery in jobs will leave unemployment at 12.1% for the year.” “The latter part of our forecast (through 2012) calls for health care, professional and business services, exports, construction and technology-related manufacturing sectors to generate a bit more robust growth in California.”

The Anderson report is another estimate of a “jobless recovery”. Their conclusion is that the state will grow more rapidly in the following two years but that job creation will not be fast enough to push the unemployment rate below double digits until 2012. “Unlike other deep recessions, the rapidity of the recovery, at least on the unemployment front, will be muted”…

To read more here is a link to additional coverage from UCLA Anderson:
http://newsroom.ucla.edu/portal/ucla/ucla-anderson-forecast-u-s-recovery-160346.aspx

Commercial and Investment Real Estate is both a global and local investment that is influenced by many factors including macro economic conditions. If we can assist you with commercial real estate in northern California please contact us at JimandNahz@ctbt.com or call us at (916) 375-1500

Sacramento Market Conditions

This month, June 2010, the magazine Western Real Estate Business has a profile on the Sacramento Market. With our colleagues at Cassidy Turley we contributed to the commercial real estate market review. Here are a few of our observations.

SACRAMENTO

Like most markets around the country, the Great Recession has severely impacted the overall state and morale of the Sacramento area in all facets and in some aspects even more so. Some of the effects have been dramatic job loss, wage losses, soft tenant demand, increased vacancy rates, plummeting rental rates, depressed housing values, rising residential and commercial foreclosures and tightened credit practices to a decline in consumer confidence and spending. Unemployment exceeded 13 percent in March 2010 from the mid-5 percent range pre-recession as a substantial number of jobs, more than 80,000 wage and salary jobs, have reportedly been lost in the area since mid-2007. Commercial real estate vacancies have climbed to new highs as rental rates have plummeted. It was reported in early 2010 that for every six businesses open, one was closed in greater Sacramento; this is a very staggering statistic.
New construction projects, namely office-oriented, that were funded a few years ago during the last market recovery were still being completed through 2009, which continued to add further strain to vacancy rates. Many retailers, from small shops to big box, have been forced to close their doors as a result of the difficult economic climate that has resulted in depressed consumer confidence and a drop in retail sales. Some large and small retail tenants have recently begun to emerge or re-emerge in the marketplace, but there still remains a lot of vacancy to fill.

Additionally, home prices have plummeted from their pre-recession levels, while foreclosures have climbed, with the latest figures showing more than 56,000 foreclosures since the start of 2007 in the Sacramento area. The city’s housing sector has been one of the most negatively impacted statewide although there are signs that it is beginning to right itself. In the commercial sector, a significant amount of foreclosures have been realized and a sizable number more are expected. In recent reports, the Sacramento metro area ranked No. 3 in the nation in terms of bankruptcy filings. However, the problems in the commercial sector are not anticipated to be as significant on the metro economy as the residential market.

— Ken Reiff is a managing partner with Cassidy Turley BT Commercial’s Sacramento office and Jim Gray is a leasing and sales specialist.

Here is a link to the entire article: http://westernrebusiness.com/articles/JUN10/highlight1.html

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

Read The Headlines... There is good news there too!

Signs of Hope. Yes, if you look closely enough, right there in the headlines, there are glimpses of good news and maybe, just maybe, indications that a recovery is “around the corner”. It is pretty easy to get focused on all of the bad news but there is good news out there! You can see signs of hope and progress in the headlines. These indicators might not be “on top of the fold” but they are there, and they provide us with indications of our resilience and that things will get better. Here are a few recent examples worth noting.

California unsold home inventory down by half. This article sets forth the statistics showing that the housing market has improved in some regards. It was reported in the Sacramento Business Journal on February 26, 2009 that
· California had a 6.7-month supply of existing, single-family detached homes in January of 2009, less than half the 16.6-month supply it had in January of 2008 -- if homes were sold at the current rate -- according to a report released Thursday.
· The California Association of Realtors reported that the median number of days it took to sell a single-family home dropped to 49.9 days in January of 2009, compared with 70.8 days for the same period a year ago.
· Home sales increased 100.8 percent in January of 2009 in California compared with the same period a year ago, while the median price of an existing home fell 40.5 percent=
· Closed escrow sales of existing, single-family detached homes in California totaled 624,940 in January of 2009 at a seasonally adjusted annualized rate and statewide home resale activity increased 100.8 percent from the revised 311,160 sales pace recorded in January of 2008.

Sacramento is No. 21 in the U.S. in energy efficient buildings. We firmly believe that “you won’t change it if you don’t measure it and report it”. An important phenomenon to watch is that green buildings will reduce our carbon footprint while at the same time lowering expenses to tenants and raising returns for landlords. . It was reported in the Sacramento Business Journal on March 3, 2009 that
· According to the U.S. Environmental Protection Agency, Sacramento has the 21st-highest number of energy efficient buildings in the country with 45.
· Los Angeles has the most buildings with the EPA “Energy Star” rating, with 262, followed by San Francisco with 194 and Houston with 145. Those cities are followed by Washington, D.C., Dallas-Fort Worth, Chicago, Denver, Minneapolis-St. Paul, Atlanta and Seattle.
· “Energy Star buildings typically use 35 percent less energy and emit 35 percent less greenhouse gases than average buildings,” said EPA administrator Lisa Jackson, in a statement.

Community Banks Growing Amid Recession. Unfortunately we have been too focused on the “big banks”, and the creation of or the need for a “bad bank”. Here are excerpts from an article on the growth of regional and small community banks from the Sacramento Business Journal on March 10, 2009. The Independent Community Banker Association of America released a survey of their members.
· It shows that the majority of the banks have seen an increase in deposits as a result of getting new customers, while only 17 percent have seen customers draw down deposit accounts.
· “While the financial crisis has affected banks of all sizes and in all regions, community banks continue to lend and are typically faring much better than the larger banks because they didn’t participate in the high-risk activities that led to problems we are experiencing,” said Camden Fine, president of the ICBA. “This survey clearly shows that the vast majority of community banks are well-positioned to survive the economic downturn and, perhaps, even reclaim some of the customers from larger banks.”
· The survey found that 55 percent of banks increased deposits as a result of new customer acquisition.
· Community banks are getting new customers at a faster rate than in the past, the survey found, with 57 percent of respondents getting an increase in new retail customers during the second half of 2008, compared to the first half of the year. The survey found 47 percent of independent banks saw an increase in new business customers.
· And the survey found that community banks are making new loans, with 40 percent of respondents experiencing an increase in loan origination compared to the year earlier

California will get $51 Billion in stimulus funds. The Sacramento Business Journal of March 10th Reports “The Keynesian relief package will soon arrive and be put to use in the Golden State.”
· California and its residents will receive an estimated $50.7 billion from the American Recovery and Reinvestment Act signed by President Obama February 17th 2009, including $18 billion in federal dollars that can be used to offset General Fund expenses.
· Funding in the stimulus package is intended for various purposes.
· Funding designated for California in the stimulus package includes $11.2 billion additional funding for Medi-Cal, the state health care program for the poor. There is also about $5 billion in educational block grants.

Construction costs continue to drop. This is really good news for any investor or business person willing and able to pursue construction or development activities at the present time. The Sacramento Business Journal reported on March 10, 2009 that
· Commercial building construction costs decreased 5.77 percent in the first quarter, compared with the fourth quarter, according to Turner Construction.
· Construction costs have dropped 2.59 percent since first-quarter 2008, according to the index.
· “The cost of construction has come down as construction spending has decreased and competition in the industry has increased,” said representatives of Turner.
· However, construction activity in the education, health care and public sectors have continued to show strength.
· Investments are also up in "green" building across all segments. Green building projects could potentially benefit from the federal $787 billion stimulus package signed into law last month.
· The index is determined by several nationwide factors, including labor rates, productivity, material prices and the competitive condition of the marketplace.

Public transit use jumps 4 percent in 2008. This is good for the environment and good for the budget and shows signs that will sustain public transportation. This article was reported in the Sacramento Business Journal on March 10, 2009 that
· Although gas prices plummeted in the second half of the year, a report by the American Transportation Association shows that Americans took 10.7 billion trips on public transportation in 2008, a modern record.
· Those trips represented a 4 percent increase over the number of trips taken in 2007 on public transportation, while at the same time, vehicle miles traveled declined by 3.6 percent in 2008, according to the U.S. Department of Transportation.
· The ridership record continues a long-term trend of ridership growth. Public transportation use is up 38 percent since 1995, a figure that is almost triple the growth rate of the population -- 14 percent.

Keep your eyes open and notice the good with the bad. The business cycle is back and the best opportunities emerge from tough times. We believe that it is important to be realists and to not get paralyzed with fear. If you would like to discuss this blog post with us or if we can help you with a commercial or investment real estate transactions, please call or email us at Jim Gray (916) 617-4255 jgray@naibt.com or Nahz Anvary (916) 617-4257 nanvary@naibt.com. “Build on the power of our network” visit our website at http://www.naibtcommercial.com/

What A Difference A Year Makes

What a difference a year makes. Cautious optimism and value added opportunities have given way to despair, and the recession is growing deeper, unemployment is rising at over 600,000 newly unemployed each month nationally and the Sacramento region already has more than double digit unemployment. Most of those investors who acquired an investment property in 2007 and 2008 are shaking their heads and re-visiting their projections and their pro-formas and wondering where the tenants are and why rents are declining? Just reflect on the past year – the Dow Jones Industrial average has dropped more than 52% and economists report that households have lost approximately 10 trillion dollars. Consumer spending is falling, auto sales have nearly been halved, and Sacramento leads the nation in the number of auto dealerships that are closing.

The real estate cycle is back! And with a vengeance! This time the downturn is steeper than probably any other since our parent’s and grandparent’s great recession—albeit depression of 1929-1934. During this past year we have seen the decline and failure or nationalizing and forced merger of financial giants including Freddie, Fannie, AIG, Wachovia, Lehman Brothers, Countrywide, Merrill Lynch and etc. Wall Street has been battered and Main Street is bruised. Many need “first aid” but a growing number need hospice services.

A report in the March 9th edition of the Sacramento Business Journal has a headline that drives the point home clearly to us and to our industry; “Sacramento Commercial Real Estate Falls 88% in 4th Quarter”. A lack of financing alternatives and a weak economy led commercial real estate sales to plummet in the Sacramento region during the fourth quarter of 2008, most notably in the office building market, according to sales data from Loopnet and Real Capital Analytics.

The report shows a total of $275 million in office buildings with a price above $2.5 million were sold during the last three months of 2008. That’s down 88 percent from the same period in 2007, when $2.4 billion in property was sold. Sales of industrial buildings fell from $304 million to $127 million; retail building sales fell from $564 million to $223 million. Apartment building sales, however, increased from $580 million in the last quarter of 2007 to $594 million in the same period in 2008.

In the local banking environment, the Business Journal reported on March 6th that only four of eleven local banks had profitable earnings. Local banks endured a difficult fourth quarter as they pumped money into reserves, which reduced earnings and only one of Sacramento local banks had a fourth quarter that was stronger this year than last.

Some of the declines in earnings are attributable to outright losses, but by far most of the declines are from placing large sums of money into reserves to protect from possible loan losses. As the recession deepens the possibility of continuing and even larger losses are great and deepening according to most analysts and most local bankers.

These are truly tough times. There are great challenges and it will require “hunkering down” and recognizing that great opportunities will emerge –but probably not right away. Sacramento was one of the first regions to begin declining and sinking into the recession and hopefully, and likely, we will be one of the first to emerge from it! The future will be bright for those who work and invest smartly and truly bring value, good underwriting and recognize that the real estate cycle will rebound and turn upward. This time next year I am sure we will point out what a difference a year makes once again. If you would like to discuss this blog post with us or if we can help you with a commercial or investment real estate transactions, please call or email us at Jim Gray (916) 617-4255 jgray@naibt.com or Nahz Anvary (916) 617-4257 nanvary@naibt.com. “Build on the power of our network” visit our website at http://www.naibtcommercial.com/