How Will Covid-19 Affect Commercial Real Estate Values?

Image Attribution: www.newyorker.com

As California’s stay at home order is slowly lifted, our economic activity - placed into a self induced coma - is also emerging from the ether. The most common question we hear these days is what is my building worth? As recently mentioned in this space - no one really knows. For and investor - value depends upon the capitalized net income of rents. An occupant? The price of utility with which an occupant’s operation relies. In the former - how will rents be impacted and at what return percentage will the market place settle? Pre-Covid found yield requirements in the 4.5-5% range. Now. Anybody’s guess. In the latter? Will business failures cause a greater supply of functional locations from which to transact.

Today, I will take a deeper dive - anecdotally - into where commercial real estate values may be headed. Spoiler alert. In this columnist’s opinion - don’t look up.

Investors - capitalized net income. Those whom rely upon rents generated from commercial real estate approach value differently than residents of their business locations.

Let’s use this simple example. If annual net rents are $12.00 and the market return for this income is 5% - the resulting price per square foot is $240 - $12.00 divided by .05. As you can gather - a change in rents can skew the net income. If returns are no longer 5% but hop to 6.5% - a decline in worth results. Again - annual net rents dropping to $10.00 with a 6.5% return yields a capitalized value of $153 per square foot. Wow! That is a precipitous fall. In reality - the analysis is a bit more complex as things such as length of the lease, credit of the tenant, and sustainability of the income are considered.

But, simply - a decline in rent or an increase in the market return spells doom for the worth of commercial real estate.

A couple of weeks ago, an investor friend of mine shared with me a conversation he had with a tenant. Approaching a lease renewal pre-virus - he and his occupant were discussing a rate of $1.10 per square foot or $13.20 per year. Unable to reach agreement - they hit pause as the virus overtook our society. Settled at $.90 were their negotiations. Simply waiting 45 days saved the tenant $.20 per square foot. As the investor will not be selling - thus the decline in value will not be realized - he will nonetheless receive significantly less income. This illustrates how rents may adjust in the weeks ahead. Additionally, if a vacancy is marketed and takers are few - an owner might sharpen his pencil to lease the space. Yep! Another data point for rent reduction. As these new COMPS filter through our industry - rates are reset.

Owner occupants - utility. Most who own and occupy commercial real estate with their business don’t speak the foreign language of capitalized net income. You see, the value they place upon commercial real estate relies more on their use of the location and the corresponding payment for that utility. Consequently, if a cheap beater of a building has crappy loading, insufficient power, or is miles from the freeway - very few suitors will surface - making it worthless to most occupants. Making, shipping, or servicing goods carries a profit structure independent of the worth of the operation’s home. Sure. Real estate has its place in the cost structure of said products - but ultimately whether that expense is a rent check to a landlord or debt service to a lender is immaterial. The ordinary business expense is the same. I know, I know - there are infinite tax benefits to paying yourself rent vs a landlord but that’s a conversation for another column. Typically, if space is needed, the local inventory of available buildings will be scanned, toured, and analyzed. Culled will be those not fitting the amenity requirements. Considered? What rent will be paid if leased vs what will a mortgage payment harbor. Simply, value for an occupant is largely determined by the number of avails that correspond with the needs. More - fewer takers - cheaper. Fewer - more competition and presumably more expensive. Corresponding interest rates from which a location may be finance? Sure! Low rates can bridge the divide between the price to rent vs own. But, ultimately - the location MUST have the goodies.

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.