After taking a turn for the worse during the recession, it appears that L.A.’s commercial real estate market is finally poised for a rebound. Banks are cautiously considering new loans, life insurance companies and institutional investors are wading back into the market and the FDIC plans to close its Irvine office in early 2012, which points to the improving health of the region’s banking industry.
But high unemployment, rent concessions and shifting consumer preferences could sabotage uninformed investors who inadvertently venture into unstable submarkets. It seems that while investors were napping, the rules changed, and big returns in commercial real estate are no longer guaranteed.
“Overall, commercial real estate is heading in the right direction, but it’s not the heyday of 2005 to 2006 when virtually every investment paid off,” says Rocco Pirrotta, senior vice president and manager of the Commercial Real Estate Group for Wilshire State Bank. “Investors need to do their homework and partner with a creative banker because, this time, your mistakes will definitely come back to haunt you.”
Smart Business spoke with Pirrotta about the opportunities and pitfalls awaiting local investors in today’s commercial real estate market.
Which submarkets offer the best deals?
After falling precipitously during the recession, several submarkets are starting to gain traction. First, the recession virtually halted the construction of new apartment buildings and condos, so apartment vacancies are starting to decline and rents are inching up, which will ultimately increase owner cash flow and may even boost property values.
Second, retail sales were up in the fourth quarter and landlords are granting fewer rent concessions, but consumers now prefer the convenience of one-stop retail centers and success hinges on local demographics as well as tenant mix and longevity. Industrial properties have been steady performers and container volume continues to rise at our local ports, but investors should be cautious about purchasing office buildings, as companies are still reluctant to hire, vacancy rates are high and experts say it will take two to three years to absorb the existing excess space.
Finally, avoid the hospitality sector, car washes and gas stations, because many of these businesses are still struggling.
What’s the key to evaluating prospective deals?
Investors can’t rely on superficial analysis; they must review data and confirm anecdotal market intelligence supplied by owners and brokers to accurately estimate their ROI.
- Rent rolls. Review a six-month collection history to see if tenants are making their scheduled payments and to expose disparities between scheduled and collected rents, which may indicate concessions. On the one hand, investors may be able to boost cash flow as rent concessions expire, but on the other hand, financially strapped tenants may be unable to pay the higher rents and they might request additional concessions if economic conditions don’t improve.
- Tenants. Are apartment dwellers working? Are suitable jobs available in the local area? Do retail centers have financially sound anchor tenants like banks and grocery stores that draw traffic and provide critical services? Centers could be in trouble if tenants rely on discretionary consumer spending, especially in economically depressed areas. Consider the local demographics along with each tenant’s business model and customer base as these underlying factors influence a property’s return.
- Lease terms. Banks have historically preferred long-term leases when evaluating commercial deals, because tenant longevity favors the buyer. Now most commercial leases average one to two years, which could be advantageous if tenants renew at higher rates, but short-term leases also allow viable tenants to negotiate a better deal or shop the competition and defect to other properties.
What else should investors consider before making a commitment?
Investors should ignore the national trends and focus on local economic conditions that directly impact commercial real estate submarkets, since our recovery is lagging behind other parts of the country. They should also spend an entire day at the property to assess the neighborhood, traffic flow, vacancies and competing projects to see if the property attracts an ample number of customers and prospective tenants. Finally, examine the owner’s recent marketing expenditures, because abundant giveaways and free rent could be a sign of a troubled property.
How can investors partner with bankers to secure a loan?
In this age of cautious underwriting, investors need a creative financial partner who understands the need for liquidity and is willing to consider options that satisfy the needs of both parties. For example, bankers used to consider future cash flow when determining funding limits, because they assumed the owner could raise rents to cover the increased debt. Now, bankers may need to offer a smaller loan, such as an earn-out loan, where future time-sensitive benchmarks allow them to increase the loan as occupancy rates or rents rise. The lender usually agrees to fund future loan increases at today’s rates, which protects investors in a rising rate environment. Collaborative evaluations and creative financing protect both investors and lenders in this new world of commercial real estate, where not every deal is a guaranteed winner.
Rocco Pirrotta is senior vice president and manager of the Commercial Real Estate Group for Wilshire State Bank. Reach him at (213) 427-6592 or firstname.lastname@example.org.