Historically, commercial real estate afforded investors predictable and favorable returns. In fact, many of the richest Americans on Forbes infamous annual list attribute all or a portion of their hard-earned fortunes to a bevy of sound real estate investments.
But commercial real estate prices plunged nationwide by 73 percent at the start of the recession and, though values have started to rebound in some cities and sub-markets, generous returns are no longer guaranteed. Going forward, investors need to anticipate every possible scenario and run numerous pro-forma models in order to forecast a realistic return.
“You can’t make sound investment decisions in commercial real estate by relying on gut instinct,” says Dr. Tammie Simmons Mosley, associate professor of Finance, California State University, East Bay. “You have to factor-in market uncertainly, review data and employ rigorous decision-making to validate your assumptions.”
Smart Business spoke with Simmons Mosley about the due diligence that leads to sound investments in commercial real estate.
How should investors approach decision-making?
Engage a team of professionals from the outset, including a realtor and an investment analyst, so you can tap their expertise through the various stages in the process.
1) Set goals. You won’t be successful if you try to hit a moving target. Establish how much money you’re willing to risk in addition to your desired rate of return and investment timeline before creating an investment profile and searching for a suitable property. This includes knowing the specific property capitalization rate for that locality.
2) Acquire financing. Whether you plan to use equity, debt or a combination of both to consummate a purchase, line up your financing in advance so you know the parameters and can negotiate with confidence.
3) Understand local laws and taxes. Local taxes, fees and even zoning and signage regulations can impact the success of a commercial building, so be sure to research and understand the local laws and regulations before you make a purchase.
4) Evaluate the tenant base. Assess the ability of current and prospective tenants to garner customers, because the efficacy of the local trade area will determine whether tenants can meet current or future rent obligations. Then use that information to create various scenarios and estimate a realistic return during the financial modeling process.
What constitutes a viable investment strategy?
Start by examining the area’s macro trends and assessing the impact on existing commercial properties to determine the best way to spend your time and money. For example, if local incomes are dropping and unemployment is high, it may not be wise to invest in a boutique retail center until the economy improves. While an influx of new office buildings may lure tenants away from mature projects and force landlords to grant temporary rent concessions, especially if available space exceeds demand. Include a demographic analysis of the average household size, age and income, and then look at how the property has fared over the last five years and the pipeline of future projects to realistically estimate the investment’s performance over the entire holding period. Finally, link your strategy to your goals in order to create a profile of your ideal investment so your realtor can suggest properties that match your appetite for risk and desired return.
What should investors review and consider as part of their market analysis?
Consider the purchasing power of the local market area as part of your analysis. How many demographically desirable customers reside within a two-minute or three-minute drive and can they use public transportation to reach the location? Next, consider the specific site and environmental factors. Will you incur heavy environmental clean-up costs or zoning roadblocks if you want to remodel an industrial property for another use? Will property setbacks keep you from expanding a shopping center or parking lot? Review data and human intelligence to conduct a thorough market analysis.
Which pro-forma statement models help investors estimate an accurate return?
First, run a broad pro-forma statement model or financial statement that estimates the property’s annual return over the entire holding period. Then, run a monthly model for the first and second year, because equity and debt investors will want to see a more precise cash-flow estimate during the risky start-up period. Then, repeat the process using a variety of assumptions to see how the investment performs under a variety of scenarios. Run the absolute worst case scenario, the most optimistic scenario and the expected scenario to see how uncertainty impacts your rate of return. Finally, calculate your expected internal rate of return by assigning a probability weight to each model while making sure that the total weight adds up to one.
Do you have any other tips or best practices for prospective investors?
Prevent bad investments by having an in-depth understanding of the commercial real estate market, because you won’t succeed in today’s environment with superficial knowledge. Use realistic assumptions and data from reliable sources to create multiple scenarios and pro-forma statement models, otherwise, its garbage in, garbage out. Be sure to check the math in your software program or financial model, because a bad formula can misconstrue an investment’s risk and estimated return. Finally, understand the current capital tax gains treatment so you can retain every possible dollar after exercising extreme due diligence and rigorous decision-making during the investment process.
Dr. Tammie Simmons Mosley is an associate professor of finance at California State University, East Bay. Reach her at (510) 885-3316 or email@example.com.
As the founder and CEO of Guardian Commercial Realty, Robert Chavez is frequently asked his opinion about the condition of the Los Angeles commercial real estate market.
“My response often surprises those who are not in the real estate industry,” he says. “They expect the health of office, retail and industrial markets will run parallel to the general economy. Accordingly, they are expecting my response to be one of doom-and-gloom during such a volatile financial climate. The answer, however, is a bit more complicated than that.”
Smart Business spoke to Chavez to get further insight into the current Los Angeles commercial real estate markets, and maybe even predict what the future has in store.
How can you explain the ups and downs of the Los Angeles real estate market in recent years?
Current Los Angeles rents are certainly much lower than they were during the 2007-2008 landlord market. That market was fueled by an artificial skyrocketing economy and East Coast investors buying large real estate portfolios and pushing exorbitant rental rates. For example, West Los Angeles and Century City rents rose from an average of $2.50/$3 per square foot in 2002-2005 to $5/$7 in some of the trophy buildings. Even micro markets like Sawtelle Boulevard, the domain of bargain West Side rents, rose from $1.50/$1.75 per square foot to more than $3 per square foot.
This spike was short-lived, however, and once the recession took hold rates dropped. Surprisingly, rates in most Los Angeles markets have not settled to their prior levels. The landlords that overpaid for their portfolios have fought desperately to maintain value and save face with their investment partners. Downtown Los Angeles in particular has become a much more expensive place to have an office.
Downtown landlords have successfully shifted from full-service gross leases to net leases with extremely high operating and tax expenses. This shift has helped camouflage a tenant’s true occupancy cost and, once the high parking costs are added, downtown is no bargain.
How has this impacted the current state of the market?
Ironically, the uncertainty of the financial markets has created inflated commercial property values in some markets. Large pension funds and private equity entities with billions of dollars to invest must place their capital. Reluctant to invest too heavily in the stock market, there has been a very high volume of bidders driving up sales prices. It is getting to the point of astonishing many industry experts. There are numerous reports of sales at prices well above what is supported by current rents. The large investors have the financial strength and ability to wait for markets to turn. They understand there has been virtually no new speculative commercial construction in the past five years and that any new construction will be extremely expensive given the high cost of labor, materials and government fees. They believe that once the economy finally recovers that tenant demand will quickly fill the existing supply of vacant space and landlords will be in the cat-bird’s seat to aggressively raise rents, reduce concessions and make big profits. It will be interesting to see just how far the speculation continues.
What can tenants do to better position themselves given their situation?
In the meantime, tenants still have a wide variety of attractive options. The market has been fairly stagnant for a few years and it is anyone’s guess as to when there will be a material shift. Many tenants with businesses in good standing and a favorable long-term outlook are committing to long-term leases as a hedge against escalating rents. This could result in tremendous cost savings and a real advantage against competitors that may be forced to sign leases in an expensive landlord market.
Tenants with real savvy are signing long-term leases with an option to terminate mid-term. Such forethought and flexibility could provide well-timed savings to the tenants who are patient and aggressive enough to secure such a lease.
What does the future hold?
Most real estate experts believe that higher rents will be the eventual outcome. Before the debt ceiling debacle, they were predicting a real estate turnaround in the next two or three years. Given what Wall Street has recently shown us, they may be extending their predictions.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardianusa.net or (310) 882-2060.