Commercial real estate is a driving factor in the economy, but with the onset of the recession, employers began tightening their belts. This led to nationwide layoffs and a steady increase in the unemployment rate. Coupled with irresponsible lending practices, more and more residential loans defaulted, sending homeowners into foreclosure. Today, foreclosures are at an all-time high, clogging the court systems and leaving banks with an overabundance of property on their books. Unfortunately, experts suggest that the collapse of the residential market is not the end of the crisis and that the commercial real estate market is next in line for a major hit. Despite the grim outlook, investors are finding creative alternatives to traditional investing.
Increased vacancies lead to more concessions and defaults.
Commercial vacancy rates tie directly into the economics of supply and demand. That is, the greater the supply of commercial space, the less the demand, and vice versa. If the supply of commercial space surpasses demand, vacancy rates tend to increase. Since 2007, more than 7 million Americans have lost their jobs. This has taken a major toll on the demand for office space, forcing landlords to offer a variety of rent concessions. Some landlords have offered months of free rent, while others have simply reduced their asking price.
“The more sophisticated landlords have cash coffers, which are specifically engineered to weather economic downturns,” says Peter Fulton, real estate transaction manager for Tyco International. “The real question is how long can these owners hold out before giving into the all too evident change in the commercial climate? With shareholder tolerance for underperforming institutional assets wearing thin, we can expect to see further concessions from institutions having high concentrations of assets in markets that will not see significant job growth for the next few years.”
The steady decline in retail sales has also sent more and more commercial tenants packing, leaving even further vacancies. To combat the situation, landlords are requiring financial disclosures from prospective tenants before entering into leases. Despite these and other precautionary measures, commercial property owners are finding it harder and harder to meet their mortgage payments, a clear recipe for loan defaults. Unfortunately, due to the lag in the commercial market and the fact that many of the tenants are now locked in at the lower rates, the situation is unlikely to improve any time soon.
Investors are favoring income-producing assets.
Until 2007, flipping property was a lucrative venture. Once the real estate market turned south, investors had to adopt a more conservative approach. With the number of foreclosure sales and short sales at an all-time high, now is one of the best times in history to acquire distressed assets. But the decision to purchase income-producing assets ultimately is a function of the investor's willingness to take risks.
Deep-pocketed investors can afford to purchase non-income-producing assets and sit on them indefinitely. These investors can diversify their portfolios by acquiring both incoming-producing and non-income-producing assets. However, the average investor can't afford the costs of maintaining and/or carrying a property for years on end. For these investors, income-producing assets are the logical alternative. “Investors are heading that direction already, particularly with single-tenant, triple-net-leased properties,” says Greg Woulfe, development associate for Morgan Property Group. “In these uncertain times, investors are looking for a rudimentary investment with 'auto pilot' income, backed by a credit tenant. … It is as conservative as real estate investing gets.”
Another technique investors have employed is acquiring high-valued properties at low cost by offering all cash. “Once the investors acquire the property, they refinance it at today's rate and lock in a renter whose monthly check more than covers their mortgage payments,” says Ryan Herman, CEO of the Herman Trust. At the height of the market, multitudes of unsophisticated investors poured their savings into properties, setting aside almost nothing to cover their mortgage payments. As a result, “many of the foreclosure properties have fresh coats of paint, brand new lawns and modern appliances,” Herman says. Properties in this condition are conducive to renting almost immediately. In today's market, income producing assets such as these are a favorite among most investors.
Innovative lending increases debt-based financing availability.
In general, the financing market is thawing for qualified purchasers. In fact, the number of commercial real estate loan originations increased significantly between the first quarter of 2009 and 2010. Despite stricter borrowing requirements, banks are becoming more and more willing to extend financing. In addition to banks, life insurance companies and the Small Business Administration are stepping into the fold.
Though banks and life insurance companies lean toward shorter terms and lower loan-to-value ratios, “an increasingly popular alternative has become Credit Tenant Lease or ‘CTL’ financing,” Woulfe says. In a CTL arrangement, the investor finances the property and pledges the rents to be received from the tenant as security. CTL financing emphasizes credit quality of the tenant and lease structure. CTL maximizes the loan-to-value ratio, but minimizes the annual cash flow to the investor. The advantage is the property is owned free and clear at the end of the term. CTL liquidity is provided through pension funds, endowments, trusts or insurance companies looking for secure income. This and other creative methods of financing are become increasingly available.
By having a basic understanding of the economy and utilizing a conservative approach, commercial real estate investors can weather the economic downturn and even end up in the black. Do not hesitate to contact an experienced attorney and/or practice consultant before investing in commercial real estate. It willsave you time and money.
— Jeffrey Fauer is an associate with Tripp Scott in Fort Lauderdale, Fla.