2023 Predictions

Yes. I’m feeling the pressure - as last week proved I was quite prescient in my prognostications for 2022. My crystal ball was in fact clear. Good thing it dropped before 9:30 this year as I was snug in bed by then. But I digress. So akin to those holiday goodies you gorged and now have resolved to avoid - here is yet another prediction column for commercial real estate.
 
Industrial real estate. Third party logistics providers will give back space. If you’re unfamiliar with the term - 3PL or third party logistics provider - allow me to explain. Simply, a 3PL is an outsourced warehousing service. Say you’re a company that needs to get your product distributed to Walmart but don’t have the space or inclination to do so yourself. Enter the 3PL who will charge you - by the pallet - to receive, store, re-package, and ship your goods for you. For the past three years - to keep up with the demand of online shopping - 3PLs thrived and leased hundreds of thousands of square feet of logistics boxes. With the “de-inventorying” currently occurring, these providers need fewer square feet. But there’s an issue as many signed term leases which still have time to go. Therefore look for much of this excess to enter the market as sublease space.
 
Recession? I vote no. How’s that for contrarian thinking! Here’s how I read the tea leaves. The Fed came out with guns blazing last year with three .75% and one .5% rate bumps. As we’ve discussed, this increase affects the rate in which banks borrow. The theory is more expensive money will cool a white hot economy as businesses will re-think borrowing for expansion. If you look at Gross Domestic Product or GDP for the third quarter of 2022 - it actually increased over Q2. By the time you read this, we’ll have a glimpse as to how the fourth quarter fared. Now couple that with core inflation which has declined for several months. Finally, retailers are shedding inventory as mentioned above. In fact this is deflationary as things are on sale. Now some might counter by opining - we’ve not felt the full impact of the Fed rate increases, folks are spending that idle cash left over from the pandemic, and massive layoffs await. We’ll see. I choose to believe in the resiliency in the US economy. Plus. Did you visit a mall, restaurant, or attempt to book a flight during the holidays? Bedlam!
 
Return to the office. Much has been written on this subject. We’re starting the third year since all of us were forced to return to our spare bedrooms. Remember that fateful day in March of 2020? Like yesterday! Fortunately, our team had spent the previous few months figuring out how to duplicate our desktop mobily. Did we have insider scoop? No. We just wanted the flexibility to do stuff in a client’s lobby, our dining room, or the front seat of our car without losing productivity. We were lucky. When the order came - we simply unplugged, drove twenty minutes home and plugged back in. Many were not so lucky and found themselves grappling with how to remain viable. Others simply ordered a bunch online and ate alot. I heard this from a friend. 😎I predict workforces will return to the office this year. Sure, a hybrid model will be employed where - as an example - Tuesday-Thursday will be office days and Mondays and Fridays will be optional work from home.
 
Retail. A continuation of the experiences that brought us back to brick and mortar stores in 2022 will continue. As examples. On a recent visit to Main Place, we were serenaded by era dressed carolers, and our grandsons thrust into a cube of stuffed animals as human claw machines. I’ve never seen the place so packed! My wife and I commented - what recession? Sans these experiences, however, I’m afraid the on-line shopping is easier. What’s avoided are out-of-stocks, surly clerks, crowds, and no parking. Speaking of Main Place. Our favorite parking spaces are now consumed with a multi family building which is under construction. Providing your own customer base and foot traffic - once the units are fully occupied - is always a great idea. But how cities choose to eliminate tax basis while at the same time increasing police and fire service remains the tug-of-war.
 
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.
 

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.