Trends

Over the past three years we experienced changing markets. By that I mean the dynamic between buyers and sellers that sets stage for negotiation and results in transactions. 
 
At the beginning of 2021 - as we slowly awakened from the ether of pandemic lockdowns, two trends emerged - rampant on-line shopping and hybrid work forces. Both of these affected commercial real estate and the three asset classes - office, industrial and retail - in different ways. Owners of industrial spaces - especially those equipped to welcome logistics providers - saw a rabid increase in demand. Fulfilling on-line orders quickly and efficiently required more on hand inventory - read. A place to receive, stage, store, and distribute said goods. 
 
Conversely, as our shopping experiences turned from visiting our local retailer in person to surfing the web - foot traffic to brick and mortar stores lessened and spaces became ghost towns. On the office front, tenants choreographed a thoughtful dance of safety of work forces vs in-office appearances. We realized we could ply our trades from most anywhere - our home, from the front seat of our cars, or abroad - and many did. Therefore, office and retail tilted toward tenants and industrial spaces were heavily slanted in owner’s directions. 
 
As we dawn 2024, the aggressive pursuit of available inventory by industrial tenants has ebbed, investor activity has been reduced to a trickle, and we’re seeing signs of lease rate softening. 
 
In light of changing markets, how should you - as an occupant of industrial space - tender your offers? That, dear readers, is the focus of the balance of this column. 
 
Know the trends. At the beginning of 2023 we counseled  our industrial occupants to watch lease rates. Our prediction was significant softening would occur by the end of the year - and therefore, to transact at the beginning of the year might result in a rate higher than anticipated. Our gamble proved prescient as we experienced a declination of rates - in some cases by 25%. 
 
Know the metrics. A simple review of how many available properties within a certain size range exist versus how many similar properties have leased or sold, is a good way to measure the velocity of a market. As an example, if during the past year three buildings between 25 and 35,000 ft.² have leased or sold, and presently there are 15 available, one could surmise that five years of supply exist. This, of course, assumes everything stays the same, pricing is not reduced in order to spur demand, or something outside our economy causes the need for space to increase - i.e. a pandemic.
 
Understand the owner’s situation. If an owner is currently carrying a vacant building, it’s important to gauge how willing she will be to accept a deal. For someone who purchased the building at the peak of the market with the appurtenant increase in operating expenses, and potentially debt service, her willingness to strike at a number less than her carrying costs might be difficult. By the same token, if an ownership has existed for many years with low operating expenses, and little to no debt - any deal might look appealing. 
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.
 

Institutional vs Private

One of my predictions headed into 2024 is that we’ll see an uptick of buying activity - especially from institutional purchasers. Why you may be wondering? For three reasons. Number one. Most haven’t transacted since the middle of 2022 and must to balance allocations. Number two. We should get clarity this year about one of the metrics that determine commercial real estate value - rental rates. Number three. A declining interest rate environment which will make Treasuries less compelling and real estate more so. 
 
Allow me to add color to these three reflections. But first a quick review of my definition of an institutional investor. If you’re a teacher, firefighter, police officer, or work at city hall you can relate to a potion of your paycheck that’s deducted to fund your retirement. Prior to the predominance of 401ks, Private employers also provided pensions and took a slice of your salary to do so. If you pay into a whole or universal life insurance policy - those premiums must be invested as well. All of the above form pools of capital that need returns and are used to buy stocks, bonds, money market funds and commercial real estate. Each asset class has its own percentage the fund managers dictate. Advisors - at the direction of fund managers - use these funds to make buys. Thus an institutional investor. 
 
Now to that promised detail. 
 
Pencils down. When we began 2022, institutional interest in commercial real estate was rabid - especially if you owned and operated a company from your building - you had many buyers knocking on your door. The play two years ago was to purchase the real estate and provide the occupying company a lease-back of preferably two years in duration. Demand during this period of time drove values to unseen levels. In some cases doubling the amount buyers were willing to pay by double. The theory was by 2024, rental rates would far eclipse the lease back amount -therefore, providing a greater return on the investment. However, when the Federal Reserve started to hike interest rates in the middle of 2022 - coupled with global uncertainty - we saw a shift in Investor attitudes. The term, “pencils down“ permeated the industry. For the entirety of 2023 this outlook continued and institutional investor activity was reduced to a trickle. 
 
Where are rents. One of the fundamental metrics in the world of commercial real estate is rental rates. Think of it as the heartbeat of the industry. The coming year holds the promise of clarity in this crucial metric. As I’ve written in the space, rents in class-A industrial in North Orange County seem to have found a level that has spurred demand. So why is this so important? Imagine you're considering buying a commercial property. You need to know how much rent you can expect to charge tenants. If this number is vague or uncertain, it's akin to navigating in the dark. But when you have a clear picture of expected rental rates, it's like having a bright guiding light. Clear rental rate data allows investors to make informed decisions. They can assess whether a property is undervalued or overpriced, which ultimately impacts the return on investment. It's the linchpin that can make or break a deal.
 
Rates. Now, let's talk about something that affects every investor's decision-making process - interest rates. In 2024, we're looking at a landscape of declining interest rates. But why should that matter for real estate? Picture this. You have some money to invest, and you're considering your options. On one side, you have Treasury bonds, historically considered a safe bet. On the other side, you have commercial real estate. Traditionally, when interest rates on Treasuries are high, they're a compelling choice because they offer a relatively safe and stable return. However, when interest rates start to drop, as they're doing now, the risk ratio changes. Suddenly, the returns on Treasury bonds become less appealing, while the potential returns from real estate start to become more compelling. Investors look for opportunities that offer higher returns, and that often leads them to the commercial real estate market. In a world where real estate can provide solid returns in a low-interest environment, the appeal of this asset class becomes evident. It's a shift that institutional investors can't afford to ignore.
 
So to sum it up. 2024 holds the promise of an exciting year for commercial real estate. Institutional investors, with their careful balancing of allocations, eagerly await clarity on rental rates as they navigate the changing interest rate landscape. These factors, when combined, create a compelling case for increased buying activity. 
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.
 

Advice I’m Giving These Days

As I pen this, we begin the second week of 2024. National Football playoff matchups are set, the first Professional Golf event is in the books, Washington v Michigan takes center stage for the NCAA football championship - Go Huskies, it feels like winter in socal as temps dip into the thirties at night, the television and movie industry awarded the Golden Globes, and the Iowa presidential primaries are just over a week away which officially begins an election year. Yes! A lot is happening. As 2024 ramps into full swing, here’s the advice I’m giving to my owners and occupants of industrial buildings. 
 
Look at total cost. Generally, our annual transaction mix is around 70% leasing and 30% sales. 2023 was no exception. 2022 reversed that ratio as we experienced a buying frenzy in the first half of the year. But as I mentioned in my annual prediction column last week, I expected some rate softening last year and we got it. For context, let’s use a 40,000 square foot building in the Inland Empire. In January 2023, the prevailing ask was $66,000 per month triple net - rent net of operating expenses. By the end of 2023 it had dropped to $54,000 - an 18% decline. However, ignored in that calculus are the “gross up expenses” of property taxes, insurance, and costs associated with mowing the lawn, servicing the air conditioners, and keeping the roof water tight. These vary widely. For an owner who purchased his building recently, expect these extras to be approximately $6000 per month. The low end - for an owner who’s held title for many years could be half - $3000 per month. Added to our triple net rates and a $54,000 per month cost escalates to a range of $57,000-$60,000. We advise clients these days to consider the “grossed up” rates when comparing alternatives. 
 
Buying. More buildings for sale will hit the market this year. Fueled by vacancies - not experienced in years - some owners will cash out vs originating new leases. We just completed a deal where the owner spent 36% of the leases future income just to attract our client to his building. Downtime, abated rent, beneficial occupancy, refurbishment, tenant improvements, and paying commercial real estate professionals for their representation are among the expenses necessary. We’ll also see sales of buildings to their tenant occupants. I’ve mentioned many times in this space - your best buyer is your resident. What about interest rates, you may be wondering? Some wise person once opined, “you marry the building, you date the interest rate”. Focus upon the price you’re paying. You can always refinance if rates settle lower. Also, consider owner financing. We struck a sale last year using this structure. Encumbered by a long term lease that paid them effectively a 3% dividend - they were thrilled to sell, carry the paper, and get a higher return. Plus, the crush of taxes is protracted. 
 
Expiring lease. If you occupy a building under a lease arrangement and your lease expires sometime in 2024, we advise proceeding with caution - particularly if your lease commenced prior to 2021. Lease rates have experienced an exponential rise, but are now softening. Depending upon pon the nature of your ownership - private or institutional - you may be able to strike a renewal at a rate below that of the market. Pay special attention to the owner’s cost to replace you. Remember the example above where an owner spent 36% of his future income just to secure a resident? Some owners can’t afford to do this and are willing to reduce the rate in order to keep you. Look to class-A industrial buildings as well. our prediction is that these rates will soften and you may be able to get a better building for the price of one that’s a bit more antiquated.
 
Election year. Jonathan Lansner did a masterful job reviewing election year trends as they affect our economy. If you didn’t catch his piece, I’d highly recommend you find it, cut it out, and pin it to your bulletin board. Enough said. 
 
Cap rates. We pay very close attention to a United States Treasury instrument known as the 10 year treasury note. Commercial lending, as well as capitalization rates closely follow this indicator. We started to see a fairly astronomical rise in 10 year notes last year. They reached a crescendo in November topping 5% for the first time in a couple of decades. They’ve now settled back to a more reasonable level of around 4%. Simply, you can invest idle cash and receive a risk free return of 4% on your money. Many opt to do this versus investing in the uncertainty of real estate ownership. For context, this same rate at the beginning of 2022 was a poultry 1.76%. As the 10 year note, falls into the 3 1/2% range, institutional investors shift their focus to investing in commercial real estate, which has the effect of lowering capitalization rates. This could spell a spate of buying activity by the big boys.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.
 

Predictions 2024

Happy new year! If you’re reading this, most likely you’ve already blown two or three resolutions. That’s ok. Just resolve to read this column each week and you’ll be fine. Well. At least you’ll be up to date on all things commercial real estate. Last week, I reviewed my prognostications from a year ago. I must admit, getting a perfect score - nailing all my predictions - was better than watching Alabama return to Tuscaloosa defeated, but I digress. Today, I turn toward our newly minted 2024 and what to predict this year. 
 
Industrial lease rates will soften. This time last year, a client of ours was facing an expiring lease. We tried to find a suitable alternative to move his operation. Nothing was ideal. We advised him to stay put, negotiate a short term fix - 6-12 months and continue our search. His owner would only agree to six months so we had a new deadline - June of 2023. We nearly struck pay dirt in March but jettisoned the opportunity due to its size - just not quite big enough. Once again, we approached his owner asking for some more time. He agreed to extend through December. Our gamble paid off as we secured a suitable building at a 15% discount! Why, you may wonder? Simple economics. We tracked new avails and ones leaving the market and noticed an imbalance. Yep. More was coming than going. We knew someone would drop their rate to secure a great tenant. Expect more of the same this year - especially with Class-A buildings above 100,000 square feet. At last count in the OC - eleven were open for business and seeking a resident. Two left the market last year. Hmmm. Someone will get motivated and make a deal, comps will reset to the new level and the frenzy will begin.  
 
Expect sales volume to increase. The forces outlined in the paragraph above will trickle into the sales world. By that, I mean  an owner awaiting a tenant may choose to sell. A further catalyst could be the underlying debt on the asset. Imagine you’ve originated a short term construction loan to build a class A structure. You considered construction costs, time to build and lease. Your calculus was based upon conditions in early 2022. You’ve delivered a new building into an entirely different market - longer vacancy and lower rates. Your lender might be getting a bit nervous. When will the maturing debt be repaid?Thus pressure to dispose of the new build. 
 
Recession or no? I say no. Last year I took a contrarian approach and predicted we would avoid a recession in 2023. Recall, recession is a decline in gross national product for at least two quarters. I believed in the resiliency of the United States economy, especially the consumer, and we skated by a recession in 2023. As I write these predictions today, the only storm clouds I see on our horizon, are global uncertainty in the Middle East. Specifically, will the Red Sea shipping lane disruption cause inflationary pressures on goods delivered? If this proves to be the case, the federal reserve may be persuaded to delay cuts in interest rates, which are predicted for this year. However, I’m reminded of our status in January 2020. We were rocking along when a microscopic foe sent us to our spare bedrooms. Therefore, beware of the Black Swan event. 
 
Interest rates. Last year, for the first time in a couple of decades, you could actually make money on idle cash. We saw a peak in Treasuries occur last year when the 10 year T-note eclipsed 5%. The rate this morning is slightly above 3.8%. This is good news for borrowers, bad news for savers and could cause an uptick in institutional buying activity. These behemoth money managers are constantly seeking return and might view commercial real estate as a safe haven to earn some additional juice. I believe the 10 year notes will level at around 4 to 4.25% percent this year.
 
Ok. So there you have it. My commercial real estate crystal ball. Best wishes, dear readers for much success in 2024. 
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.