This is the first "Chief Brief".
When looking at the demand in the business of commercial real estate, I think there are a variety of factors to consider. They are:
Leased space demand.
Commercial mortgage demand.
Commercial real estate services demand.
Investment property demand.
Leased space demand.
The crash of the housing expansion and overall residential real estate market has had considerable impact on employment. Unemployment has caused vacancy rates to skyrocket in office and manufacturing space, has had negative effect on industrial, distribution, and warehousing properties, as well as almost every class of retail space. I think that until we experience significant increases in job creation, we will not have demand for further development, in any of the aforementioned classifications, nor will we see a swing back to a meaningful increase in absorption of the current vacancies. Jobs drive commercial real estate demand.
Commercial mortgage demand.
The housing crisis lead directly to the capital markets meltdown. The CMBS debt packages were co-mingled with sub-prime and other “financially engineered” debt products that were soon exposed as significant risk, and in most cases, caused these huge packages to be unable to be effectively underwritten, and thus they became “poison assets”. The buyer pools ran in the opposite direction and the mortgage and investment bankers were left holding the bag-with no buyers. This effectively took the knees out from under the conduit mortgage business which were at that time, originating approximately 65-70% of all commercial debt. No replacement product or program has emerged, and none is in sight. There is an estimated $1.8 Trillion of CMBS debt maturing in the next four years, without a cohesive plan or capital source for refinancing, except a recently coined strategy of “pretend and extend”. Which is a nice way of saying “stick our head in the sand” and hope the values hold up by pushing out the term, and pray that another capital source returns to the market. The demand for quality commercial debt is and will be considerable. My concern is whether a supply will materialize-in time.
Commercial real estate services demand.
As the ancient Greek philosophers said, “The only constant is change”. There will always be a demand for commercial real estate services, as there are, and will always be owners that have no desire, aptitude or resources to operate, lease, sell, manage or finance their assets. The question will be in what area will there be an increase in demand for these services?
With the recent economic deterioration, quality leasing services will be likely be in the highest demand, especially if there is a fallout in leasing agents unable to sustain in a much more “hit and miss market” with a greatly reduced opportunity for earning.
Demand for asset and property management services will likely remain the same, with some of the players being replaced by specialists like receivers, as many properties will go into default and or foreclosure and lenders will want to protect the assets. Demand should also increase for special loan servicers who will assess current property conditions, develop a plan for continued operations, negotiate with borrowers, and make asset based decisions, including the hiring of receivers, property managers, and leasing and sales brokers.
Investment property demand.
Buy low sell high. One would think that this strategy would be more than achievable. Overall commercial property values are estimated to have dropped by 20-40%, so arguably one can “buy low”. The mystery is whether the values will continue to drop, thereby delaying or preventing the rise in value that necessitates the “sell high” part of the old real estate adage.
The current demand for commercial real estate is dimmed by three major factors.
Lack of debt capital. Although debt exists, it is in low supply, the terms are less palatable to investors, and the risks are not in alignment with the current cap rates or pricing. Why would an investor take significant recourse mortgage risk, coupled with the inherent risk associated with commercial real estate in a very unstable and unforgiving economy? Demand is definitely driven by favorable financing.
Lack of market confidence. Until the American consumer feels confidence in the economy, the value of their most significant investment (their home), and do not fear losing their job, they will not shop, which sadly is the driving engine of America’s financial health. Currently there is no confidence to invest in commercial real estate.
Lack of 1031 Exchange activity. Most brokerage metrics put their investment sales figures at 7-20% of 2007 numbers, while 2005-and 2006 were even better. With transaction velocity this low, 1031’s are almost non-existent. Another significant factor is the aforementioned decrease in property values. Even if a property owner sells, he/she is not likely to experience enough appreciation to recognize significant capital gains, which is the main driver of the 1031 tax deferred exchange.
Obviously, institutional investors are less impacted by tax ramifications and debt constraints, but their confidence levels remain low, and they are “staying out of the pool” until they can see the bottom. The same can be said of the riskier, value–add, opportunistic individual investors.
Once we see a long-term, fundamentally sound commercial real estate market, that behaves with a modicum of predictability, we will experience an increase in commercial investment demand.
Michael K. Houge, CCIM, SIOR
(Chief)
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