Commercial Real Estate remains edgy from current market operating conditions: limited capital, extremely tighter underwriting, shrinking net operating incomes, shrinking space demand and declining property values.
“By mid 2007 it was apparent that the “Great Gatsby Era” of Commercial Real Estate had come to an end. The months following constituted a downward spiral of unraveling residential real estate portfolios which spread rapidly into commercial portfolios by the end of 2008 and beginning of 2009.” –Charles Rankin, President Rankin Commercial Properties
For commercial real estate companies today, that means leaner and more efficient operations and more focus on tenant retention rather than tenant attraction.
Rankin Commercial Properties was formed as a Full Service Commercial Real Estate Firm in order to help “lean down” on operating costs for commercial property owners in North Carolina. The company offers inhouse cleaning and janitorial, landscaping, maintenance, construction, and facilities services in combination with the traditional property management and brokerage services. In doing so, Rankin Commercial Properties can shore up expenses, spread the overhead costs, and help commercial property landlords save considerable amounts of money.
“…the “Great Gatsby Era” wasn’t just a pecuniary boom for Commercial Real Estate Tycoons; it had also become an economic “cakewalk” for service providers. Commercial Brokers had the luxury of slamming signs in the ground and collecting phones calls, general contractors added 50-60% profit margins while hiking salaries, and other property service providers enjoyed the constant climb of service fees from nonchalant property managers.” –Charles Rankin, President Rankin Commercial Properties.
Rankin Commercial Properties (RCP) was originated in Late 2007 with the vision of constructing a fully integrated commercial real estate company to offer commercial property owners quality, affordable services accompanied with proactive management and aggressive brokerage services. RCP materialized a year later with the closing of 4109 Wake Forest Road, its first rehab project.
How long will these current conditions remain in effect? Is the smart money is starting to act as if it expects the current operating environment will be in effect for some time and start to look for opportunities that match the times.
Despite some signs of overall economic stability, commercial real estate is still reeling from the effects of the credit crunch while trying to avoid the recession’s knockout punches. At the same time, they know the cycle will eventually turn will eventually come to an end.
“We probably have already experienced the worst, but our economy is still falling, albeit at a slower pace. Several leading indicators suggest that we will likely bottom out before the end of this year,” said Tim Wang, Ph.D. and senior investment strategist for ING Clarion in New York. “Nonetheless, property investors should keep in mind that the economy declining at a slower rate is a lot different from actually beginning to expand. The recovery process could be less robust and take longer than expected. We believe that there will be more distressed assets coming to the market over the next 12 to 18 months,” Wang said. “Property Investors with cash can cherry pick the best assets in the most desirable markets. Preferred equity, mezz debt, super senior CMBS and ‘loan-to-own’ are also attractive investments during this period.” – Paul J. Ruff, president of Triumph Real Estate Corp. in Englewood, CO, agreed that there are very early indications that an end of the recession may be in sight — somewhere in the next several months.
However the end isn’t next month, continuations of reductions in job losses through the next two or three quarters, will offer some hope but won’t put a lot of money back in consumer’s hands, and a return to growth is another story, because inflation and rising interest rates resulting from the stimulus is a real threat, and that will hold down spending and hiring.
What does all of this mean going forward? First, lenders want more equity in the deals (whether it’s a new loan or a refi). Second, prices have already dropped in most markets to the point where a lot of commercial properties are under water or close to it, which will continue that downward pressure on prices because lenders will be taking back more commercial properties and selling them at a discount to get them off their books and property owners will be selling them at a discount to avoid going back to investors to raise additional capital for a refinance.
But Charles Rankin with Rankin Commercial Properties thinks there’s another way. “Paying ridiculous amounts of money for services rendered to these properties needs to stop. Sure, it isn’t helping the economy any, but a significant reduction in operating expenses will help keep up with the increasing CAP rates and essentially make it easier to refinance. Commercial properties aren’t losing tenants as fast as people think, at least not in Raleigh, North Carolina. Commercial Real Estate Brokers simply aren’t able to do deals because they haven’t been properly trained to prospect for tenants. Proper marketing techniques, cold calling, and sincere drive will keep properties leased.”
“Commercial Real Estate Brokers in Raleigh, NC have dwindled to lazy sign posters and commercial real estate property managers have offered property service contracts to great ‘relationships’…. well, right now you simply can’t lease a property by just throwing online or putting a fancy sign out front. You can’t properly list properties when you have so many you can physically only spend 2 hours a week marketing them. Furthermore you can’t operate properties at high service rates because that’s just who you have a good relationship with.” –Charles Rankin
The disconnect between what commercial property sellers want and what commercial property buyers are willing to pay is clearly pointed out by looking at sales volumes around the country-anemic compared to any “normal” year.
Because of the pricing disconnect between buyers and sellers of commercial real estate, many in the industry are mining the books of lenders looking for nonperforming loans, foreclosed properties and pending loan maturities as a place to extract current opportunities.
“We still have commercial property owners trying to sell properties at 7-8% CAP rates. It’s not happening. Then they try to reduce their costs to raise the CAP rate by firing their service providers and doing it themselves. The problem there is that the property then goes south because tenants see the lost property services and could care less about the landlords struggles. That’s why Rankin Commercial Properties is a full service commercial real estate firm in Raleigh, NC. We can reduce the costs, raise the CAP rates, and retain the tenants.”
With falling NOIs and corresponding lower property asset values, commercial real estate owners will be hard pressed to refinance and retain property ownership of their leveraged assets over the next 12 to 24 months. As banks begin or continue to foreclose on commercial buildings, many of these institutions will be forced to make hard decisions about their move-forward strategy for these assets. As the economy begins to recover, well capitalized commercial real estate buyers will have many assets to choose from, both distressed and non-distressed, since, as we’ve heard so many times recently, if you have money, you won’t find a better time to be a buyer.
Based on conversations and business meetings, banks are getting into the commercial real estate business. If a workout cannot be accomplished on a default, banks will foreclose.
REO (real estate owned) opportunities are rising. It will be similar to the RTC days. People chasing notes are the first wave of property investors stepping in. Purchasing notes have advantages but some serious disadvantages. What needs to happen is the foreclosures to happen expediently with the understanding that lenders are going to off load the commercial properties just as fast.
No commercial real estate investor is going to accept the prices that banks are trying to dispose of their assets because equity is expensive and the rules of the game are still changing. Immediate opportunities will continue to be those where property investors are buying the notes at less than par (if the banks get rid of them at that price) with the expectation that these troubled loans are really REO opportunities.
CMBS/Commercial lenders and their servicing agents are going to be drinking from a fire hose shortly as we are seeing an increasingly large waive of troubled assets enter foreclosure. For the next 18 to 24 months, we are in for a rough ride downward as commercial real estate lenders continue to foreclose these troubled assets and more importantly sell them off at very low price-per-square-foot prices. Commercial Property Owners need to position themselves as best they can to compete with the REO product in terms of rental rates and concessions; which if they are underwater is going to be tough to do.
“Property leasing activities of larger competitors are already turning into 12 month concessions. How can commercial property landlord’s compete? We recently leased up a 34,000 SF Office Building in Raleigh, NC from 41% leased to 94% leased by offering turnkey solutions to tenant office spaces, several months free rent, and all at higher rental rates.” –Charles Rankin
“Because our commercial real estate services are all in house, we were able to completely renovate the property under a planned scenario that worked well with the current cashflow of the office property. Even though our office leases included some free months rent, the tenant upfits were nearly paid for by the advance rent paid at lease signing. After all the tenants moved in, we operated the property at the previous levels (due to free rent concessions) for a few months, then BINGO, the new tenants rents started hitting the books.” –Charles Rankin, President of Rankin Commercial Properties.
The commercial real estate industry as a whole will shift from transaction oriented to property management oriented. Returns from commercial real estate are made up of income from cash flows (NOI) and appreciation; traditionally 70% from cash flows and 30% from appreciation. The past five years or so have seen the majority of returns stem from appreciation due to cap rate compression not NOI growth. Now that cap rates are headed back up and probably will not return to historic lows in the next five years, returns have shifted back to cash flows as the main source. Real estate companies that have a core property management focus will be well poised to assist property owners as they seek ways to increase their NOI by filling vacancies, increasing rents and reducing operating costs. “This is what Rankin Commercial Properties is all about” said Charles Rankin.
Traditional transaction brokerage companies will survive, but on much less volume. Further, companies that can show a strong track record of property management, leasing and disposition work will be well suited to partner with commercial lenders who are forced to hire “work-out” firms to help delinquent sponsors that lack these basic skills.
The real estate industry is not in transition from one cycle to the next, it is undergoing a major transformation that requires new strategies, new business models, new business practices and new systems. There are many positive long-term trends and opportunities, however, getting there requires vision, leadership, capital and a knowledge- and customer-centric focus. Some of the areas of opportunity include, but are not limited to: energy; waste management; healthcare; data storage; government; R&D; trade; pharmaceuticals; corporate campuses; defense and security; high tech; green industries; FIRE; back office services; and infrastructure.
Commercial Real Estate Companies will have to become leaner and more efficient. It’s a well known fact that many large commercial brokerages have not only let go their lower performing sales people, but more importantly a lot of the staff that supported those people. The opportunities coming out of the recession will in part be related to the accumulated market knowledge and more and stronger relationships that the survivors gained in the downtime, which only full-time immersion in the business can provide. Bad times can be a great opportunity to sharpen skills, take courses, clear your desk and your mind, refine marketing tools and techniques, and allow time to plan new strategies and tactics, some longer range planning than we are usually able to do during the busy times.
In terms of positioning for recovery, the big issue today is people making hard decisions to cut muscle (the fat has long since been cut), and not knowing when/where that muscle will be necessary in the future. The emergence of boutiques from all of those who have gone out to start their own firms will be interesting. Some will be very creative/successful doing interesting things.
The industry is also optimistic in office leasing. There is always a need, and the number of businesses far outweigh retail operators and landlords. During the next two to three years, commercial real estate companies that are faring well, comparatively, are going to be able to take advantage of the drastic cuts in office rents, and increases in landlord incentives. Over the next 12 months, landlords are going to realize that anything resembling the $200/PSF era of the 2006/2007 leasing bubble will not be able to compete in the new economy. The supply and demand rules are in complete effect, and with supply at its current levels landlords are going to have to adjust. If they aren’t able to adjust (because of their break-even point) they are probably going to be in distress. Which then brings us back to bank foreclosures, and the need for everyone to face reality.
There will certainly be pain to endure on the part of landlords, as many markets have seen rental rates start to soften and concessions have increased significantly. As loans mature and landlords look to restructure or renew their debt, many will face difficulties with higher vacancy rates and stagnant (if not decreased) base rental rates on their rent rolls. It seems that those companies with financial strength and long term perspectives would be wise to negotiate (or renegotiate) long term leases right now for those corporate locations that are deemed to be stable in the coming years. The company with long range strategic planning and the ability to make decisions will create tremendous value in the coming years as a result of transactions with excellent economics right now. With that being said, for branches or offices with uncertain futures, it makes sense to negotiate short-term renewals while ensuring for maximum protection and flexibility in the lease document.