commercial real estate

Here’s what I wrote for KLNB’s market report covering the state of the Office/Industrial market in the Baltimore Washington Corridor (but much of it holds true for the national commercial real estate market as a whole):

The last quarter has brought with it a dichotomy of sorts in the demand for commercial investment real estate in the Baltimore Washington Corridor. The appetite from institutions for well-located, quality real estate – particularly class A buildings in the most desirable business parks – remains strong and prices for this product have held steady or increased. Relatively older or less-well-located assets have seen demand from investors diminish, and yield expectations from prospective buyers of that real estate have risen commensurately.

Driving this dichotomy is the widely publicized cred
it crunch on Wall Street. Fears of widespread default on residential mortgages have irrationally spilled over into the commercial side, despite leasing fundamentals – particularly in our region – that remain strong. As a result, Wall Street-based originators of debt slated for securitization– the lenders that have offered the most attractive terms available and have financed the majority of investment real estate that has changed hands in the past several years – have much less money available to lend.

These lenders – popularly referred to as “conduit lenders” – have become much more selective about which properties they will finance, and their money is much more expensive to borrow. Spreads — the margin over treasuries at which these lenders set their interest rates– have increased today from a range of 95 to 110 basis points over the corresponding treasury before the crisis up to a 200 to 250 basis point spread today. Complicating matters further is the fact that the market is extremely volatile and pricing changes almost daily. The other major sources of financing for larger commercial real estate acquisitions – life insurance companies and banks – have always been relatively conservative; as such it is not surprising that these lenders have not moved to meet the unmet demand for inexpensive financing.

Institutional buyers (real estate investment trusts, pension fund advisors, and the like) are not as reliant on this sort of financing and as such have continued to bid aggressively on a very selective basis, focusing on the most desirable assets in the market with almost as much relish as before the credit crisis. Capitalization rates well below 7 percent still are the norm for the most sought-after “core” office and industrial assets in the Baltimore Washington corridor, despite a lending environment where borrowing is occurring at loan constants between 7.75 percent and 8 percent. In this range of pricing, where debt provides negative leverage (meaning financing lowers the cash-on-cash-return), financing-dependent private investors cannot compete with the institutional buyers.

Class B and C assets that cannot attract interest from institutional buyers are not changing hands as readily. There is market disequilibrium; many sellers have not adjusted their pricing expectations downward to meet the yield expectations of the private buyer that demands at the very least modest positive leverage from his debt. Practically speaking, at today’s interest rates, an investor needs to buy at a capitalization rate that is higher than 7.5% to 8.0% to garner positive leverage, and needs to do meaningfully better than that if the asset requires significant ongoing capital expenditures.

Owners that refinanced before the credit crunch with assumable financing – and secured record low rates and often an upfront interest-only lasting for several years– will benefit doubly when it comes time to sell: buyers will be thrilled to assume that financing and will be able to rationalize higher prices than they could if that below-market-rate financing was not in place.

User-buyers are paying the highest prices in the marketplace today, as (a) interest rates still remain near historic lows and (b) these users are more focused on the overall cost of ownership versus that of leasing and ownership frequently wins out in that analysis today. Many an owner of late expends significant time, energy and expense filling a building with tenants to ready it for sale, only to later learn the unhappy irony that the building would be worth more empty (to an owner-occupant) than full (to an investor).

More than a few would-be buyers and sellers are taking a “wait and see” attitude, with sellers expecting that the market “froth” will subside, and buyers boldly predicting greater crisis and opportunistic buying opportunities to come. Prudent sellers will price their assets appropriately and move to sell while rates remain low, rather than trying to “time the market.” Appropriately-priced and widely marketed assets still generate multiple offers from the investment community. Buyers looking for opportunistic buying opportunities are not yet finding them: there is little-to-no distress among owners of commercial real estate in the Corridor. Distress, where it exists, is nascent and primarily in the residential sector.