An Interesting Investor Conversation

Last week, I wished you all a Merry Christmas. This was my way of adding some levity to decorations appearing in stores the last week of September. But I then got serious and discussed the chats I’ve had recently with investors, tenants, and owner-occupants. If you allow yourself to listen, interesting challenges are disclosed. If you missed the column - below is a recap of what I’m hearing from investors.
 
From last Sunday. Investors. Our industrial market crossed a pivotal point in the middle of 2020. For the first time I can remember, the occupant premium disappeared and investors started paying more for offerings than those who bought them to house businesses. Deep pools of capital, a rabid appetite for return in a stable asset class, and skimpy supply caused pricing to hit a crescendo in May of 2022. With all the world happenings - inflation, recession, global strife, and rising interest rates - investors, especially institutional investors, have hit pause. Private folks are proceeding quite cautiously. Many require debt to acquire income properties. As rates have now eclipsed 5.5% - the resulting capitalization must be north, lest negative leverage will occur (return on invested dollars less that cap rate). So with fewer buyers and higher rates - yep. Prices have started declining.
 
Another week and several more conversations. One in particular I believed was column worthy. We are marketing an investment opportunity in Chatsworth. Included is the owner’s desire to sell the building and remain - after the close - as a tenant. Known as a sale-leaseback, this deal structure has curried favor recently as our values have eclipsed sanity. This particular offering has a bit of hair, however - configuration, company ownership, and re-use once the occupant vacates in ten years. Yes! Investors are concerned with the next round. Akin to a game of billiards where the current shot pales compared to the “leave” - investors look past the return today vs their risk once the tenant bales in the future.
 
As the market changes - an investor’s propensity for risk is padded by a need for more return. Generally, institutional investors - those which are publicly traded or invest pension funds as correspondents - seek one of two types of deals - a core or value add. The former falls right in the mayor’s office the latter involves some work to get the engine revving. Our listing is neither. Plus, with the market and global gyrations, many institutional types are playing wait and see and not transacting.
 
What buyers are left? Private capital. Your neighbor that owns a strip shopping mall or office building. Many private investors have considered our listing. Most have passed. Too risky if the tenant leaves, we don’t like the layout, how do we retrofit the building in the future, and what insurance do we have the occupant will remain in residence - are common refrains. But another interesting dynamic is occurring. Unless motivated by the need to place money via a tax deferred exchange, private capital can earn 3-4% investing in government treasuries. These afford a return of 10x versus a year ago and come with the full faith and credit of the United States government - very little risk. So, if faced with investing in a risky real estate deal with a return of 6% compared to the alternative of the bonds…yeah. Me either. Also, if I’m buying at a 6% return and I choose to finance the purchase - I must be keenly aware of my borrowing costs as loan constants are now north of 7%.
 
Allow me a simple example. Let’s assume you buy an income property for $2,000,000. If $1,000,000 is borrowed at 5.5% interest - the simple interest payment is $55,000. Easy. But, how is the $1,000,000 principal repaid? That’s where amortization comes in. A fancy way of repaying the principal over the loan term. So. If the $1,000,000 principal is repaid over 25 years at 5.5% interest - now the annual payment is $73,690. Your return on the $1,000,000 (rent from your tenant) is $120,000 but your loan payback is $73,690 - for a net of $120,000-$73,690 = $46,310. See the problem? Your $1,000,000 invested brings in $46,310 per year. Take the same $1,000,000 and throw it into treasuries and you make $40,000. Hmmm.
 
So what does all that mean? Continued downward pressure on pricing. If you want to sell to a private investor, be realistic. Times they are a changin! 
 
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.

Is a Commercial Building Worth More Vacant or Leased?

As we’ve discussed - commercial real estate is owned by those who occupy it with a business or investors who rely upon the rent the property produces. Therefore - a slice of commercial real estate is valued according to its utility - in the instance of an occupant or to an investor - in its ability to produce income. Occasionally the lines cross - which I will cover in the last section.

Utility varies. Think about it this way. If you’re a company that tools aerospace parts - the electricity feeding a property is critical because you use it in your operation. Without the amperage - the parcel is worthless to you. A logistics company that stacks products in a warehouse relies upon the number of truck doors and inside ceiling height. Therefore - utility is found in a property with such upgrades. An easy way to consider utility? Generally, an occupant considering a selection of buildings will place a greater emphasis on utility or use in its decision. Said occupant is willing to pay more if the commercial real estate has the features he seeks.

Income production. Rent. How much? How certain? How long? Easy. Let’s assume a building has market rents and is leased to a Fortune 500 tenant for ten years. So, there is very little risk. The valuation is simple - an investor will buy the income stream for a price. His price? Easy math. Annual rent divided by his desired return - also knows as a capitalization or “cap” rate. Thus, an annual lease payment of $12.00 at a 6% return yields a value of $200 per square foot. Consequently - your 20,000 square foot building is worth $4,000,000.

If a building is vacant - is it of no value to an investor? If he is smart - certainly not! However, the analysis is more complex and the stars must align for the resulting price he can pay to compare to an occupant purchase. Here’s the way it works. Since an investor relies upon the income - rents - a property produces, he must calculate what those rents will be, how long it will take to achieve them, and at what cost. We refer to this as lease origination expense. If he’s looking at a vacant building and the seller wants $200 per square foot - the investor must factor in the origination expense. If an investor can pay the $200, absorb the origination expense, and still get his return - golden!

If a property is leased - is it worthless to an occupant? It depends. Keep in mind - an occupant looks at utility. And he must be able to occupy the building. So, if the PERFECT site - with all the bells and whistles - is available but leased for awhile - it might still work. Here is how. We recently represented a buyer. Obligated for two years in a lease - they wanted to pursue a purchase for their next move. So, if we located a building for sale with a short term lease in place - that was beneficial. We did! Plus. Because the lease on the building we bought was short term - the buyer got a better price. Because - most investors were turned off by the impending lease expiration and most occupants couldn’t wait two years to move. Boom!

When do the lines cross. We are seeing a fair number of investors buying vacant buildings these days. Recently - a high percentage of the structures in a new development in north Orange County were sold to investors - vacant! Their motivation? Money needed to be spent. Capital had to be deployed. It was costlier to wait than to buy vacant and incur the origination expense. A similar trend is occurring inland where new logistics boxes are trading without tenants in place. The reason? More occupants are seeking leases vs purchases. As an investor - if you can buy the right utility - your origination costs are reduced, you create the income, and the world is a happy place.