Commercial Realty Is Undergoing a Transformation
by Aaron Mesmer
Invest wisely within that new environment.
For the past decade, commercial realty professionals have lived in a world that is positively Dickensian—the best of times, and the worst of times. Until 2007, it was difficult to lose money in commercial real estate (CRE) and financing was available to all. In 2008, the market reversed course, and the clouds didn’t begin to clear until 2010. Occupancies and rental rates began
to stabilize, prompting debt and equity capital to return.
CRE investment transactions were up 19 percent in 2012, a trend that is expected to continue in 2013 as yield-starved investors seek higher cash flows derived, in part, by the availability of cheap debt. Still, the recovery has been uneven across property types, property classes and geography. In Kansas City, apartments are the darling of investors large and small. Distribution warehouses, medical offices and net leased properties are also in high demand. However, traditional office and retail properties continue to see stubborn vacancies, limited rental growth and shallow investor demand. For CRE investors, it is imperative to explore why the market is currently bifurcated and how to apply the hard-earned lessons of the previous cycle to decisions today.
The most important lesson is that demographics are king over all. In some ways, this adheres to the old adage of location, location, location. Buy where people want to live, work and shop, with the expectation that these areas will fare better in terms of occupancy and rent growth over the long-term. This has driven down yields in the 24-hour cities (DC, LA, NY, SF) as investors scramble to place bets in markets with limited supply and high barriers to entry. Lower returns in major cities have caused some investors to seek alpha in the secondary markets of the Midwest, resulting in increased pricing for multifamily and industrial properties in places like Kansas City to near-peak levels.
Understanding how people utilize space once they arrive at home, work or the store is critical in order to avoid buying properties with functional obsolescence. For example, the maturation of the echo-boomer generation into young adults is driving apartment developers into a near arms race for amenities—coffee bars, universal Wi-Fi access, collaborative social spaces and resort-style spas. That can leave owners of older properties scrambling to keep up, least they suffer the consequences of lower occupancies, lower rents and scathing online reviews (OMG!).
Technology will continue to be a key factor in space demand across all property types. An increasing number of corporations are experimenting with working remotely, working in open collaborative spaces or “hoteling” desk space, any of which could limit demand for new offices. Conversely, the growing market share of online retailers has given rise to a new class of supersized (imagine 25 acres under one roof) distribution and fulfillment warehouses near transportation hubs.
The last lesson is a cautionary tale regarding the use of excessive leverage. The use of debt to increase returns in commercial real estate is a generally accepted practice, but overleveraging can be crippling to any CRE investment. For industrial, office and retail properties, 75 percent is the rule of thumb for maximum leverage; 80 percent loans are commonly placed on apartments. But other loan terms must work in harmony to meet investor objectives.
A few practical tips for investors weighing CRE investment options:
• What are your investment objectives? Protecting and preserving investor capital? Strong risk-adjusted cash flows? Opportunities for appreciation?
• Seek out experience, expertise and a strong track record.
• Invest in quality. First-class properties that outperform in all market conditions.
• Be skeptical and ask questions. A good sponsor should be able to clearly articulate the value proposition, their management capabilities, the capital structure and the anticipated exit strategy. A good CRE investment opportunity has a thesis that can be defended.
• Evaluate the capital structure. Is the sponsor putting in his own cash at risk alongside yours, or are they expecting sweat equity? Are the objectives of general and limited partners aligned properly? How much debt is involved, and under what terms?
• Differentiate overall market trends from individual opportunities. Not all apartment deals will meet expectations and not all office transactions are bad bets. In times of panic, babies and bathwater are often treated the same way.
At its most basic level, commercial properties derive their value from the rent tenants are willing to pay, so it is critical to understand the underlying supply-and-demand fundamentals.
As the economy continues its recovery, commercial real estate occupancies are rising along with rental rates in Kansas City. Those who don’t learn from the past are condemned to repeat it, but CRE investors who apply their knowledge to today’s opportunities will have the ability to outperform competitors and achieve strong risk-adjusted returns.
Aaron Mesmer is a principal specializing in acquisitions for Block Funds in Kansas City.
P | 816.412.5858
E |amesmer@blockllc.com