Two Key Ingredients Missing for Bargain Hunters: Office Markets Haven't Bottomed and Lenders Aren't Lending
|When will long-expected thaw reach the distressed office market?|
There was much talk last year
about the billions of dollars amassed by various investment funds for the purpose of purchasing distressed or value-add office properties. And while it's clear there is no shortage of buildings that fall into that category, there are precious few office building sales of any sort getting done.
Currently there are more than 19,600 distressed office buildings in 50 of the largest U.S. office markets, and that number is growing daily, according buildings analyzed by CoStar Group using the web-based CoStar Property Professional data product
. (For the purposes of this analysis, CoStar tallied office buildings in those markets that are currently 40% leased or less.)
That current number of distressed office properties is 8.6% more than it was a year ago. And the it is particularly acute in markets throughout the Sunbelt states, which also not coincidentally happen to be at the epicenter of the housing market collapse.
The amount of office buildings falling under this distressed category has been growing at more than double the national rate in six markets: Austin (35.9% higher than a year ago), Inland Empire (33% higher), Los Angeles (20.7% higher), Phoenix (20.5% higher), Southwest Florida (20.2% higher) and San Antonio (18.3% higher).
In addition, Phoenix led the country by percentage of distressed buildings to the total number of buildings in the market at 11.1% compared to a 6.5% average. Detroit had the second highest percentage at 10.2%, Las Vegas third at 10.1%, Atlanta fourth at 9.8% and Southwest Florida fifth at 9.1%.
While some markets have a higher percentage of distressed office buildings than others, "the pain seems to transcend all markets, which I read to mean that the credit crisis is not discriminating between and among historically strong and not strong markets," said Thomas N. Trkla, chairman and CEO of Brookwood Financial Partners LP in Beverly, MA "And, I think the numbers are going to get worse."
Click here to download the table of number of distressed office properties in 50 of the largest office markets in the country.
The reasons for the dearth of deals appear to come down to three primary factors: the pricing disconnect that exists due to rapidly declining market fundamentals, tightened credit conditions, and a lack of appetite for risk on the part of bother lenders and investors.
"Although we have been actively looking to acquire commercial real estate assets, whether defined as value-add opportunities or assets from distressed sellers, we have not closed a single transaction in this period," Trkla said. "For most of 2008, the biggest reason for this was the huge bid/ask spread that existed between buyers and sellers. Since the stock market crash of last fall, we have witnessed increasing capitulation on the part of sellers, who are now intent on getting the best price they can for their assets."
"Where we have lost deals is a difference of opinion on what market rate rents will be when currently above-market leases roll," Trkla added. "We think that sellers and especially the brokers who represent them are far too aggressive in this regard. Our belief is that real estate fundamentals will deteriorate further in 2009 and likely into 2010; however, we see transaction volume increasing as more and more sellers own to the new realities of pricing and underwriting assumptions."
What needs to happen for that money to start flowing is obvious, he said.
"Prices need to drop further to reflect not only the degradation in value attributed to loss of leverage, but also less aggressive assumptions on lease rates, lease costs and downtime," Trkla said. "The commercial real estate markets are only in the first year of correction as compared to the residential markets, which are in year three. There is still a long way to go before investor sentiment changes with regard to commercial real estate. Our view is that a recovery in this sector is years away. Opportunist investors can and will invest prior to the inflection point of a recovery, but to do so, they will need to achieve greater price discounts than exist in the market today."
Randolph L. Wile, principal of Wile Interests Inc. in Houston is seeing much of the same.
"Because the impact of the economic turmoil has not been as great here [Houston], I do not believe that risk has been priced into deals - yet," Wile said. "In short, prices haven't dropped substantially and, as such, there seems to be dislocation between bid and asked on office investment pricing. Credit, or rather, the lack thereof, seems to be among the biggest factors driving office investment pricing."
"Appraising in the current market is like trying to drive a car blindfolded while getting instructions from a person looking out of the back window of the car," said James S. Bradley, a real estate appraiser with Axia Real Estate Appraisers in Tucson. "I also believe that many real estate appraisers in the market do not really understand how to provide appropriate valuations in a rapidly changing market. I have seen a number of appraisals from around the country over the past few months and it appears that they are generally out of touch with current realities. Thus, lenders are being given false indications of the market, (which is) not allowing them to make appropriate decisions concerning the disposition of distressed assets, (notes and foreclosed properties)."
"I do not foresee much change in the market for distressed office properties (or notes) until their pricing is adjusted to truly account for the future benefits of their ownership and the changing reality of risks and returns in the market," Bradley added.
Boxer Property in Houston made a name for itself in value-add office properties in the recession years in the early 1990s. Andrew Segal, its CEO, thinks the lack of available financing is the only thing preventing similar opportunities from developing currently.
"The key factor remains the availability of financing before you can get to the virtues of the market," Segal said. "From my point of view, the paralysis that many building ventures are in is like a sugar rush to those who are well-capitalized: All of a sudden, very few landlords are able to fund tenant improvements and leasing commissions. That leaves some easy pickings for buildings that have access to cash. But, like a sugar rush, it will end quickly when these impacted buildings trade hands to owners who can afford to undercut the market. That was me in 1992 when I bought buildings in Dallas for $10 per square foot and started leasing for $4.90 full service. A building that had been a non-factor in the market for five years all of a sudden flooded the market with cheap space."
"There are startling few transactions taking place in Dallas and Houston," Segal added. "Most of them seem to involve either very high seller financing or a lender taking a property back after a default."
For the market to turn, Segal said lenders would have to start making real estate loans at interest rates of less 9%.
"The best bet may be for small and midsize local banks to lead the way. The spreads for them are enormous. If the regulators let them play in that market of $2 million to $20 million office and retail acquisition loans, it could get very busy here in Texas again as the value investors move in," Segal said.
Reluctant Sellers, Conservative Buyers
With little financing available in the market and a lack of consensus, buyers are still approaching the market very conservatively.
"I think it is axiomatic that pretty much all buyers, ourselves included, have become much more cautious and risk-averse," said Steven Sandler, CEO of Crosswind Capital LLC in Rye, NY. "Although few and far between, there are some transactions that are closing, (many with in-place financing), and yes, you could argue that only the premium properties are trading."
"However," Sandler added, "the definition of a 'premium property' isn't what it used to be 24 or even 18 months ago. Clearly, the current trade is not in the assumption of the risk of rental growth. The idea that a building with a tenancy significantly below market rents is a screaming opportunity, is a tale that is two years too old. What qualifies as a premium building now, is predominantly Class A product, with little or no cap ex requirements, with strong occupancy that has plenty of runway. I for one would not want to be in a position of justifying to my investors that I acquired a stabilized building that suddenly became unstabilized due to tenant turnover, no matter how under-market the current rents may appear to be."
Charles G. Cecil, partner of OpIn Partners LLC in New York, is also sticking to the strongest - or most liquid markets.
"We are only interested in the best quality locations and the better quality buildings in San Francisco, Los Angeles and Manhattan. We foresee buying in Miami on a very selective basis," Cecil said. "We are only interested in the distressed story as it plays out in Manhattan, San Francisco, Los Angeles and Miami. Our reasons have to do with our belief that they are the most liquid markets over time. We will consider scenarios where the occupancy may go down in the near future, since we employ a low- or no-leverage strategy. We are buyers at 9-10 cap rates, with low or no leverage, and believe that the good-quality properties need to be bought at this time, rather than wait for some lower valuation moment."
David Taylor, principal with Central Florida Commercial Brokers in Orlando, said some buyers are showing more tolerance for risk if the price is right -- but for the most part he said that is not happening right now, and may not for awhile.
"For any product type - office included - my 'value-add' buyers are actively working their way through potential acquisitions, albeit slowly," Taylor said. "When it comes to financially distressed Class A and B office assets, none of my buyers believe that values have stabilized at this point. For instance, I'm working with an international buyer who wants to acquire a trophy office asset in the Northeast. He was quite definitive about wanting to do so in the first quarter of 2009 until that time arrived and rents and occupancy continued to fall. Now, he has pulled back and won't consider re-addressing that acquisition until the third or fourth quarter. If the U.S. economic climate continues to sour, I'm not sure it will even happen then."
Click here to download the table of number of distressed office properties in 50 of the largest office markets in the country.
For additional comments from readers on office market conditions and distressed office properties in particular, please continue reading.
The majority of my investors are standing on the sidelines with few exceptions. Some may choose to follow the Warren Buffet school of investing and "average down" on value properties as they increase portfolios in 2009 and 2010. Once investors see a steady flat line in the Dow and NASDAQ, followed by a slow but steady uptick, I think the tide will turn and money that is standing on the sidelines will start moving on everything for pennies on the dollar. This could be a perfect storm of loan maturities and defaults meeting cash-is-king.
I have one key investor who is pacing himself for a feeding frenzy on bank REO. Most of these properties likely will be "landed banked" to a 5-year horizon and beyond. I think the hardest-hit markets, including Florida, Arizona, California and Nevada, will offer the deepest discounts but may also require the longest holding times. You also have to consider the demographics of these states (many have large populations of retirees who are dealing with wrecked retirement accounts).
For fastest-recovery locales, I am focusing my research on identifying distressed office, residential, retail property opportunities in densely populated urban centers (Boston, New York City and Washington, DC) with larger populations of younger working professionals) in 2009 and 2010.
Rachel K Maman
Boston Investment Realty LLC
An Artifact of a Former Economy
We are based in Reno, NV and one of our sub-markets, South Reno, has an office vacancy rate of approximately 30%. This is an area that experienced tremendous growth in the past 10 years and was the location-of-choice for our building-fueled economy. Now that that has all gone away, tenants are leaving, buildings are going vacant and it's beginning to feel like a ghost-town.
At the time that the South Reno market was exploding, the downtown Reno office market was imploding. That balance has now changed and those tenants that are surviving appear to be returning to downtown.
Yet, we are not in the market for, nor are we recommending that clients purchase office buildings in South Reno. That market is an artifact of a former economy, the debt-fueled, pre-sustainability boom that we had through 2006 -2007. It is not coming back to Reno and there is more pain to be had in the outlying area such as it.
Commercial Pacific Advisors
Office vacancies are high with little hope for a decrease in the near-term. Leasing momentum is limited to the "musical-chairs" of tenants moving from one building to another. The only employment sectors that are seeing some growth are education and health care, but as employers have continued to scale-back, we have begun to see even these employers slowing their expansion plans.
Office investors are not willing to take much a risk now. If debt was readily available, we might see an uptick in the transaction level. The limited amount of available capital combined with few financing options for "value-add" office properties in Michigan have caused investors to re-think their strategy and focus on more stable properties or the acquisition of debt.
Anne Galbraith Kohn
Senior Vice President
CB Richard Ellis
New & Old Competing
There is a lot of newly built product out there competing with existing properties. Due to price competition, there has been a decrease in rents and an increase in incentives to attract prospective tenants. Lenders see this happening and do not want to make higher LTV loans - that is if they are willing to lend at all. Add in the fact that some loans from 2-3 years ago are re-setting and existing owners are having trouble refinancing them.
SoCal Real Estate Consultants Inc.
I have a client who buys distressed office nationally. They prefer secondary markets with a 12%-15% leveraged return on current occupancy, and a 20%+ return on stabilization, taking into account carrying costs leasing commissions and any repairs or improvements required. They put debt on the property and will not use creative financing to push the yields (.i.e. interest only) They also prefer that the buildings be at least 50% vacant and of a size large enough to justify maintaining onsite management. If they already own in a market, they can take on smaller properties using management already in place for their other properties. They do need to be in a market that persuades them that the vacancy can be filled up over time.
Marcus & Millichap
Only REO Deals Getting Done
I used to be a commercial broker with Grubb & Ellis, but have had a real estate receiver business since the fall of 2008. I know that the office market is soft (12% vacant) and getting weaker (we had most of the sub-prime lenders based here.) The only buildings being sold are: a) out of receiverships or b) after the receivership when the foreclosure is done, sale by the bank OREO dept.
California Real Estate Receiverships
Newport Beach, CA
Why Sell if You Don't Have To?
For the NJ office market, we have had very few trades of office properties; leasing is soft; tenants paying late or downsizing is increasing. I can't find any investors interested in New Jersey office properties at ANY price because of the biggest unknown: "How long will it take to lease up the vacant space?"
Stable deals, "good properties" are not trading unless there is some peculiar reason. Why WOULD you sell if you didn't have to?
So many properties have loans on them based upon values which were pegged too high due to crazy cap rates that I don't see how they will refinance. These may represent the investment "opportunities" in the next two years. Time will tell. I don't see a scenario where things get more active in office acquisitions in NJ before the end of the year.
Director of Acquisitions
Bergman Real Estate Group
Overwhelming But Logical
It is pretty overwhelming; but logical. Offices are populated by businesses, and businesses are contracting, laying off personnel or simply shutting down. Except for certain markets that appear somewhat countercyclical, it would appear inevitable that there would be a drop in occupancies/rental rates pending a general turnaround. The good news is that there does not appear to have been the type of overbuilding that has decimated the residential markets. And if Buffett and others are correct (as I suspect they are) about inflation heading our way in the not too distant future, the office market could be a major beneficiary. But, as with life, timing is everything - so for owners facing refinancings in the next year or so without any real prospect to obtaining debt needed to satisfy existing loans, inflation won't be of much use.
Andrew T. Nichols
BGK Integrated Group
Santa Fe, NM
Fraught with Artificial Potholes
Real estate people have all dealt with recessions many times as part of the inevitable real estate cycle. It used to be that where we were in The Cycle - commonly thought of as 10 years, give or take -- life was so predictable it was almost comfortable. We all knew what to do and when, and we also knew that there were always going to be people caught without a chair when the music stopped. But this cycle, if that is what you can call it, seems fraught with artificial potholes. No doubt there is going to be a lot of fixing ahead, but as long as the banks can hold off on making decisions over and over again in the hopes that Washington is going to sweeten the pot one more time, there will be no commitment. Until the music stops for the banks, we are all just relegated to watch the dance from the sidelines.
Although the back-to-basics approach gets bandied about quite a bit, what that really means is that we have to stop looking for appreciation to drive values and start focusing on cash. Specifically, making a cash flow that will cover debt service. That's little consolation, of course, for all of those investors who bought based strictly on an appreciation bet, or even a value-add bet.
Given the continuation of the gap between acceptable bid and acceptable ask, it is probably going to take something systemic to break this log jam. Market problems such as increasing vacancies might increase interest among bottom-fisher equity investors, but if the market is to really break loose, more than likely it will have to be the lenders who will eventually insist on cash flow to make their funding decision rather than potential appreciation -- no matter what the potential upside.
President and CEO
MayfieldGentry Realty Advisors LLC