Friday, July 7, 2017

What will Cause these INFLATED Commercial Real Estate Prices to Drop?

Image Attribution: www.latitudeco.com
At their very essence, commercial real estate values are a result of the price a ready willing and able buyer, with reasonable motivation, will pay and a ready willing and able seller will accept. Easy enough.

Let's layer in some complexity, however, as the previous statements assume the ready willing and able buyer will write a check for the purchase. In reality, most buyers seek financing for their buy - which sets in place an approval process from a lender.

Typically, lenders - short of Aunt Mabel who taps her trust fund for you - will require an appraisal - regardless of the size of the down payment. Hmmm, so if the ready willing and able buyer and seller agree to a price and the lender's appraisal doesn't conform, the transaction has an issue? Yes. Absent another buyer, willing to assume the previous buyer's agreed upon price - without a lender this time - the seller must reduce his price, the buyer must inject additional cash to bridge the gap or something in between. So, the first cause of a drop in pricing would be - the property won't appraise. 

But, what are some other reasons?

A spike in interest rates. An obvious result of an increase in borrowing costs, would be higher payments. Higher payments - fewer buyer's can qualify for financing - fewer buyers, less competition - a drop. But, a spike in interest rates could also cause business activity to decline. The resulting lack of business could place less pressure on a company's need for space. Demand for space subsides - fewer buyers - Boom! prices drop.

The Black Swan event. Transactions occur when prices are increasing or when they are falling. When prices are on the up, sellers win. Buyers score when the reverse happens. Uncertainty - I'm not doing anything until this is resolved - is a result of the Black Swan event such as a war, a collapse of student loan repayment, terrorist attacks on our soil, foreign leaders who launch a missile, a government shutdown, or a county bankruptcy - as we experienced in 1994 in Orange County.

New inventory. We've been awaiting the building spree of new buildings for quite awhile. Yes. We have added some new buildings, but we have also seen many others demolished in favor of high rise apartments. In short, for myriad reasons - which will be left for another rant - the supply of newly constructed commercial real estate has not kept pace with the demand.

Buyers say enough is enough. Recently, we accepted an assignment to help a buyer find a new home for his business. When we commenced our touring of the available choices - the buyer was disappointed at the lack and of the quality of available buildings - plus the asking prices were jarring. Flash forward, asking prices have now hopped another 15%. Our tour last week was met with, "wow! how have asking prices increased that much in fewer than two months?" It dawned on me. If buyers refuse to pay the prices - which is unlikely - prices will drop.

Its akin to a giant game of musical chairs. This era of crazy money paying outrageous prices for commercial real estate WILL stop - we just know when.