Valentine’s Day

A day for lovers. Valentine’s Day falls every February 14th and is celebrated by couples worldwide. 
 
According to Wikipedia - “It originated as a Christian feast day honoring a martyr named Valentine and through later folk traditions, it has also become a significant cultural, religious and commercial celebration of romance and love in many regions of the world.” 
 
And here I thought it was an excuse to stuff my face with chocolate and those cute little heart shaped candies with the cryptic messages stenciled on their sides. But I digress. 
 
As I ponder Valentine’s Day, my thoughts turn to commercial real estate and the parallels I can draw. Here goes. 
 
Do you love your commerical real estate holdings? I was taught early in my career to help buyers divorce - sorry - themselves from the emotion of commercial real estate ownership. By this I mean the numbers should guide your decision to buy or sell - not your feelings. I reflected upon an owner I met who owned a freestanding single tenant building in Anaheim. He was a builder. He had constructed this holding. I was engaged to be his agent whenever a vacancy was pending. Every three to five years the panic would creep in as he knew his cash flow would soon stop and he’d be forced to suffer a dry spell. His negotiating leverage was lessened and he ended up with some sketchy residents. All because he needed someone, anyone, to pay the rent. Over serious objection - after all, this was his baby, I convinced him to sell the building to an occupant and trade the proceeds into a building with multiple tenants. My theory was if you lost one or two occupants, you still had money to pay the bills - not the in and off light switch of a single tenancy. Reluctantly, he agreed. He’ll tell you that was the best decision he ever made! He now owns three such buildings and enjoys a great retirement. 
 
Send your tenant a valentine. The new year is in full swing and a good benchmark to finish old business and start new. Many landlords reconcile the past year’s expenses with their tenants in February. The crush of year end is solidly in the rear view and the first quarter is half over. If you budget your operating expenses such a property taxes, building insurance and maintenance annually, you’ll need to make certain assumptions. Now that the true costs are known, you can bill your resident for underpayment or credit for overpayment. Second half property taxes are due in February. Send in your payment this month. The county assessor will love you for it. 
 
Negotiation, compromise, and commitment. In both commercial real estate deals and romantic relationships, negotiation and compromise are key. Whether it's negotiating terms of a lease or compromising on where to go for dinner, the ability to find common ground is important. Commercial real estate investments often involve long-term commitments, similar to the commitment involved in a serious romantic relationship. Both require careful consideration and planning for the future.
 
You marry commercial real estate. You date the interest rate. For those of you who are a bit concerned about interest rates  these days, don’t forget your deal can be refinanced once interest rates settle into a more favorable level. Focus upon the basis under which you acquire the buildings. By this I mean the price you pay. If you can separate your emotion, as discussed above, and focus on the income producing capability of a commercial real estate asset, you’ll make a smart buy.
 
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.
 

Subleases

Sublease listings remind me of a half yearly sale at Nordstrom. You better get there early in the markdowns to get a deal of selection and price. The longer you wait, the price gets better but the selection wanes until your only choice is an XS purple long sleeve tee. But. The price is unbeatable. If you’re like I am, an XS tee only has once use - that of a dish rag. But I digress. 
 
Much has been ballyhooed about the amount of industrial space coming back to the market - so I did a little research. My trusty spreadsheet is not quite as robust as Jonathan Lansners, but I made it work. 
 
As a quick review, a sublease is a remnant sale of sorts. When an occupant originates a lease agreement, the contracts vary in length. Depending upon the size of the premises, lease terms range from 2-10 years. Many times smaller buildings mean shorter leases. If an occupant can’t - or doesn’t choose to - fulfill the term obligation, they’re faced with three choices. These are a buyout from the owner, a default, or a sublease. A buyout is best for the tenant as they are relieved of the remainder for a fraction of the cost. Since the owner takes the risk and expense of finding a replacement, the situation must be quite compelling. A default is least palatable for both parties - owner and occupant. Subleasing is a nice compromise. The tenant markets the excess space in hopes of locating a surrogate to live out its lease term. 
 
So, on to the numbers. 
 
Presently, in all of Orange County, 92 listings in excess of 50,000 square feet exist. Of these 92, 12 are subleases or 13%. Los Angeles county came in at 497 listings, 73 subleases for 14.6%. Inland markets, spanning that vast swatch of industrial space to our east, clocked in at 245 listings of which 34 were subleases or 13.8%. Most of the give backs appear in square footages above 100,000 square feet. As an example, in the IE the percentage jumps to 16%!
 
Ok, you may be wondering, why does this matter. Allow me to expand on a few reasons. 
 
Market impact. The most valuable subleases in the industrial market closely mimic that of a direct lease. By that I mean the term is long enough for an occupant to spread his moving costs over a period of time. Using our Nordstrom half yearly sale as an example, a beautiful suit in your exact size at a 30% discount is much more appealing that one two sizes too big which will then need expensive alterations. Your savings are eaten up by the expense of making it fit. Plus, in some cases, all sales are final and you can’t take advantage of Nordstrom’s generous return policy. Subleases are similar because all sales are final. Your benefit is in the discounted price - not in other concessions such a tenant improvements. 
 
Additionally, subleases have a downward push on market lease rates. Of the 12 buildings currently available for sublease in Orange County, all will trade at a rate significantly less than that direct listings. With a few of these, the discounts can be explained as anomalies. However, if a large percentage of leasing activity is with these remnants, an adjustment of pricing occurs because the pricing is driving demand. 
 
Occupant considerations. In a sublease arrangement, the tenant becomes the sub-landlord, and the surrogate becomes a sub-tenant. Many occupant/sub landlords price their sublease at a slight discount versus a direct lease with an owner. In my opinion, this is a mistake, because a sub lease really needs to pop and provide a shock and awe price to attract demand. 
 
In order to affect a sublease, you must seek and gain approval from the owner of the property. This approval may not be unreasonably withheld, but it’s a step which must be accomplished. An unauthorized sublease can create a default, which is never advisable.
 
With your surrogate in place, don’t forget you, as the tenant, are still ultimately responsible for the lease obligation. Yes, you’ve located someone to pay the rent in your stead. However, if they fail to pay rent or break another lease covenant, the owner may look to you for a remedy.
 
Owner considerations. If your tenant is financially viable, and has simply outgrown your building thus the need for a sublease, your position is generally pretty solid. If, however, your occupant is struggling for other reasons, such as a downturn in business, or an industry collapse, it’s important to pay close attention to their process of locating a surrogate. Depending upon your tenant’s lease rate compared to the current market rents, it might make business sense to allow your tenant to buy out of their obligation. Under this circumstance, you take the risk of finding a new occupant, but avoid a potential bankruptcy by your tenant which could tie up your real estate for several months. Ultimately, you have the right to approve anyone that wants to sublease your building. As mentioned in the paragraph above, this cannot be unreasonably withheld, but it’s well within your purview to require a use compatible with your building to be sought along with a financially viable group.
 
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.
 

Selling Motivation

What’s selling motivation, you may be wondering. True that! We’ve not experienced much since the middle of 2022 when the Federal Reserve mounted its stair climber and hiked interest rates several times over the next eighteen months. Most of the selling motivation from the start of 2021 was fueled by crazy high prices investors were willing to pay paired with cheap money. Some never considering a sale of their property cashed in during this run up. We even saw the occupant premium disappear for a few months. An occupant premium refers to a higher price the user of a building is willing to pay versus that of an investor. You see, occupants consider the utility a piece of real estate has to offer its operation whereas an investor is interested in the income generated. Generally, that means they’ll pay more. Once the easy money evaporated and investor buyers were relegated to the sidelines - selling motivation ebbed. I believe in 2024, we’ll experience a different kind of selling motivation - more forced selling. Bear with me as I review five situations that could render me prescient. 
 
Transition triggered by one of the Ds. Transitions can predict a sale. Most common among the transitions owners face are divorce, death, disposition, distress, disputes, and dissolution. When a marriage ends and the combatants must reconcile the assets, sometimes a sale occurs. Death creates an interesting tax treatment known as a “step up in basis” which makes selling more attractive. Sometimes business owners decide it’s time to sell their companies. What follows, occasionally is the sale of the building the operation occupied. A vacant address with a mortgage means someone must foot the bill. Distress happens when no one wants to rent the premises. Arguments can lead to a sale. When partners can’t agree on a direction for the property, selling could be imminent. Finally, when an ownership entity is dissolved a property is sold. Effectively ending the involvement of the members. 
 
Lender pressure. Here’s my theory. Stress among regional banks has been widely reported - especially, if the bank has risky loans on the books or faces upward rate pressure in its bond portfolio. The demise of Silicon Vally Bank and First Republic are examples. If a bank funded construction loan was originated at the beginning of 2022 - which financed the construction of a new building - certain assumptions were made. These included the costs, the time to complete the build, the lease rate that would be achieved, and the amount of carrying time before an occupant moved in. The expectation was a permanent loan would replace the short term construction loan. But now the new structure is delivered into a very different world - lease rates have softened and vacancy times have expanded. Plus interest rates have risen substantially. Lenders fear their construction loans may not be timely repaid and could force a sale. 
 
Owner capitulation. Refinancing into a higher interest rate market could bring some owners to the table with selling motivation. This will especially be true with the owners of office properties. If the owner of an office building faces substantial vacancy, and must resort to lowering its lease rates to attract a tenant, the income generated by the office building is less than anticipated and may not service the debt. Additionally, if substantial capital expenditures are necessary in order to attract occupants, the money may not be in the budget. As you can see, a tsunami of issues could cause a seller to hand the keys to their lender. The lender, not wanting to own commercial real estate, then disposes of the property at a discounted amount.
 
Short term rollover. We currently represent an occupant looking to acquire a building in the Inland Empire. During 2021, this business owner was effectively blocked from purchasing because he could not compete with the investor activity. Investors were willing to pay astronomical prices with very few contingencies, and close quickly. Therefore, we sold and leased back for two years. Our theory was we could re-buy before lease expiration and we believed the market was headed for a correction. We are now noticing some building owners, faced with a pending vacancy, looking to sell rather than experience the lengthy and costly process of originating a new tenancy.
 
Investors awakening from their slumber. Who knows when we’ll see an uptick in investor activity. My prediction is this genre of buyers - faced with allocation requirements, a declining interest-rate market, and a realization of where lease rates have settled, will cause some buying activity this year. The interesting part of the equation will be how owners - not faced with any of the pressures above - will react to unsolicited investor offers. We shall see. 
 
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.
 

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.