Buyer Brokerage for Office Tenants

 Many firms have a person inside the organization who would be in charge of leasing office space. In many cases, they have a narrow range of buildings that they are considering, and most of those buildings would have leasing agents. It seems simple enough to have that person call the various leasing agents, gather information about the lease terms and availability, and compare the needs of the firm against the possibilities. 

Especially when dealing with professional firms, there can be an attitude that the real estate agent does not have much to add.  This is not usually true.  The leasing agent for the building represents the landlord, and, while s/he can show the space and prepare the lease, that falls short of everything a tenant would want to know.  Knowledge of the local market, terms common to the neighborhood, landlord concessions, and fit-up allowances are all important.  Understanding what to ask for is a key part of the leasing process. Good agents are in touch with current practices, and may be aware of going rates, even before they are published or can be used in an appraisal.  Since appraisers can only use information from closed transactions, there will always be a lag in that regard, unless an agent has another source.

Sometimes the leasing agent may also represent the tenant. If they are in formal relationships with both, that is called dual agency.  It must be disclosed, and agreed to, by all parties.  It is not uncommon, but having a written agreement means that there is a fiduciary duty to both sides.  Although that duty exists, it is still the norm that the landlord would pay the commissions, even for the buyer's agent.  When that is true, the tenants are receiving help and information that is not costing them anything.  

More on that last point:  Could you negotiate a better deal, if you had no agent who had to be paid?  That is a commonly held belief, but it's important to realize that, without agents, both sides expect to save money. Whether or not it happens is subject to negotiation, but it would be naive to think that the tenant would get all the savings.  Even if they did, they might pay more for the space because of scarce knowledge of the going rates, concessions, and fit-up allowances.

In some ways, it can be akin to the advantage of using a good travel agent.  You still pay the advertised rate for your trip, but you get the benefit of added background, and the commission is paid by the vendor or venue.  In fact, you may well do better with the travel agent involved, especially if you need to negotiate terms or changes.  Think of that when you consider a new office lease.  To use a real estate professional or not?  The answer should be clear.

Old Real Estate Maxim Still Rules

 When I was in business school, now decades(!) ago, I had a professor whose current work then was focused on how CEOs decide where to locate company headquarters.  His conclusion, after much research, was that the biggest factor in choosing a location was where the CEO him/herself wanted to live.  

While that isn't a shocking result, it is a little surprising that big organizations, with all kinds of considerations for transportation, labor force, infrastructure, taxes, and a myriad of other factors, would in the end have personal preference of one person as the greatest determinant.  We can see evidence of this still, in the recent behaviors of business executives during the pandemic.

Connecticut has been the beneficiary of a move out of New York City, and thousands of people have moved here in the past six months.  Yet we didn't expect that companies themselves would move, and that's turning out to be the case.  And that isn't just in the office arena--manufacturers and other seemingly less mobile property users are also in the mix.

We are getting showing requests and offers from buyers out of state, who are looking to locate where they plan to live.  There are many reasons for their choices, but it points to a brighter future for Connecticut than was predicted while tax policy and weather was causing a rush to warmer climates and distant vistas.  Now, the proximity to major metropolitan areas, combined with family dynamics, is helping us catch us with the economic progress made by other areas over the past two decades.

There are good reasons for this to continue.  Our location between Boston and NYC is obviously key.  Company owners and investors don't necessarily have to live here, but they will have employees and tenants who do.  Many family business owners also want to be where their children and grandchildren are, whether or not those generations are in the company or not.  The current focus on low density and outdoor space work in our favor, and our natural assets have become more important to real estate decisions.

Looking forward, we can see from the residential market that supply may become a limiting factor.  While none of us expected it, this uncertain age has become one of increased real estate activity, and a good time for sellers to consider putting properties on the market.  Who knew that the old research about company location would be so relevant now?

Commercial Real Estate Pivots on Product

I have a friend whose job is as a cost estimator for large construction projects.  His biggest job has been paused, not for COVID reasons directly, but rather for the changes in the post-COVID world.  The client feels that the building needs to be redesigned to provide more privacy, and less open work space.  Since most recent buildings have featured open floor plans, it remains to be seen what the demand will be going forward.  It may mean that older buildings, which might not even be Class A buildings anymore, will be desirable just because they have many small individual offices.  It also may mean that flex space will be bought and reconfigured into cubicles.

Retail spaces may also be changed, and smaller spaces may become the sought after ones.  It may also be that stores will have waiting areas, entry turnstiles, or different layouts over larger floor areas.  Some retail may get used by service industries, like exercise studios that now need social distancing room, or salons and even medical facilities, for similar reasons.

Warehouse, as I have said many times, will be prime real estate for some time to come.  The rise of e-commerce has been accelerated by the coronavirus, and that trend will continue.  Location, as always, will determine value.

It's a brave new world, and we don't know everything that will happen, but change is surely in the cards.

A Perspective on What's Next for Real Estate Investors

By Ethan Coleman, Ninth Square Real Estate Partners

By now every American is aware of the unprecedented public health emergency and economic disruption caused by COVID-19. While we remain in the early stages of both the pandemic and the likely severe recession that will result, we can begin to assess the impact on commercial real estate as we position ourselves to capitalize on potential opportunities. Before doing so, I want to first express my gratitude to those on the frontlines fighting the pandemic and helping the sick. Thank you. I also wish well all those who are affected by the virus either directly or economically. My thoughts are with you. Our primary concerns should be with those who are helping and those who are affected. I work from the comfort of my home, writing about a topic that is clearly secondary. My purpose in writing this is to begin to organize my own thoughts and research in attempt to begin for formulate a plan for future acquisitions. As a real estate investor during these times, it is hard to both react to the problems within one’s existing portfolio and simultaneously begin looking for new opportunities. These two things can feel contradictory. The problems at properties we own are real and immediate, while the potential opportunity in theoretical. I try to compartmentalize the two and not let one affect the other. So what is happening out there and what should a real estate investor do?

Real estate, unlike stocks, does not reprice constantly, so we can’t yet see what is happening with pricing for buildings yet. Deals take many months to source and close; those that close today were deals consummated prior to COVID-19. For this reason, we don’t yet have data from the private real estate market on how pricing has changed. Every broker and investor is trying to figure it out.

We have begun to see the disruption in property operations, though, and this will eventually impact pricing. For example, many retailers are closed and asking for rent relief, hotel revenue has cratered, showings are down for vacancies, and office buildings are empty as workers attempt to work from home. If these impacts are short-lived, pricing may not change much, but if many stores never reopen, renters lose their jobs and can’t pay their rent, and companies that occupy office and warehouse properties begin to go bankrupt as revenues fall, we can expect significant re-pricing for the affected real estate. For now, we can continue to monitor these initial impacts and we can look to the public markets pricing of Real Estate Investment Trusts (REITS) to begin to understand how investors are pricing the underlying real estate assets.

To translate a REIT share price to the value of the underlying real estate, I calculate the market cap and add it to the long-term liabilities, which provides the current cost basis of the underlying real estate portfolio. We then take the REITs representation of Net Operating Income from its 2019 annual report and divide it by the current cost basis to arrive at the current market cap rate for the real estate. We can then compare the current implied cap rate for the REIT’s assets with its recent high to see the change in how the public markets are valuing the real estate. This can provide some insight into how real estate values may change.

Retail

With about three-fourths of Americans in some form of stay-home order, tens of thousands of retail establishments are closed. As of March 23, over 47,000 chain stores in the U.S. had temporarily closed. In addition, thousands of independent retailers have also closed by choice or state mandate. Many of these retailers are asking for rent relief or are simply not going to pay rent in April. Some may never reopen. Retail landlords can likely endure a short-term reduction in rent, but longer-term fundamentals may be impacted by retailers going bankrupt.

Based on my analysis of the change in valuation for Realty Income Corporation, a REIT focused on triple-net retail properties, the value for these properties, long perceived as safe, has fallen by 28%. Retail Opportunity Investment Corp, an owner of grocery-anchored centers on the west coast, is down 33%. Clearly the public markets are pricing in a severe disruption to retail real estate.

Hotel

Without long-term leases, hotels must re-rent their space each day, so any change in performance is realized immediately. According to a March 26 webinar from STR, a hotel data company, for the week ending March 21, revenue per available room (RevPAR) was down 69.5%, the third week in a row of double digit declines and the largest ever in 30 years of data. Corporate demand for meetings is now down to zero and U.S. occupancy is down from 65% to 30%. China’s occupancy fell to 10% during its lock down. As a result of this decline in performance hotel franchisors Marriott and Hilton are down 47% and 39% respectively as of March 27. With this level of revenue deterioration, hotels are going to face distress much faster than other types of real estate. Values for hotels seem the most uncertain.

Multifamily

Jobless claims for the week ending March 21 hit a staggering 3.28 million, more than four times the previous weekly high. Some experts project unemployment to reach 20%. With many of the laid off workers coming from shuttered businesses, such as hospitality, tourism, and restaurants, these layoffs may begin to impact renters’ ability to pay rent, particularly in Class C apartments, often termed as workforce housing, and in areas of the country where the employment base is more heavily skewed toward hospitality and tourism. With Congress set to pass a $2 trillion stimulus package that includes increased incentives to keep workers on the payroll and an additional $600 in weekly unemployment benefits from the federal government, these effects could be somewhat ameliorated, but only for a short period of time. If the retailers, hotels, and other employers don’t re-open and quickly ramp up to their former revenue level, many jobs may be permanently lost, which will in-turn impact apartments.

While this is the most sudden deterioration in labor markets in U.S. history, it will still take some time before multifamily operations are impacted to a level that causes owners to exit voluntarily or under distressed scenarios. The extent of this pain will determine the ultimate impact on pricing. Equity Residential, one of the best-known apartment REITs, has seen the value of its real estate decline by about 24% based on my analysis of its current stock price.
 

Office

Like multifamily, the impact on office properties will be determined by the ultimate level of economic impact resulting from COVID-19. Many office workers are now working from home, which should allow companies to limit the short-term, direct effects of the pandemic. As the impact to the economy works its way through the system, though, office demand is likely to wane as companies are forced to cut costs as business activity declines. This will eventually result in some companies failing to pay rent and impact property revenue. As this plays out some property owners may elect to sell or will be forced to sell, dragging down prices.

Franklin Street Properties, an office REIT focused on properties in the Sun Belt and Mountain West, has seen its underlying real estate decline by 20%, according to my analysis. The market appears to be more confident in future of office properties than retail and hotel. But office carries the risk of a faster shift towards work from home as more companies have been forced to adapt to this during the stay-at-home orders.
 

Warehouse

Warehouse appears to be best positioned to weather a recession as vacancy rates are low and demand for logistics and e-commerce has been strong. With more people forced to stay home, e-commerce companies, such as Amazon, are increasing their hiring and look poised to increase their market share. But as overall demand in the economy goes down and consumer spending declines, companies operating warehouses are going to declining sales. Some companies will be well-positioned but others will be unable to pay rent, impacting operations and eventually property pricing. Even ProLogis, a class-A warehouse REIT, has seen its implied real estate values decline by 19% as the public markets anticipate impacts on warehouse properties, according to my analysis.

Conclusion

With property operations quickly deteriorating at retail and hotel properties and future reductions in occupancy and rental revenue likely for multifamily, office, and warehouse, it is not surprising that the public markets have devalued real estate by 20-30% depending on the asset class and location. Real estate investors must be careful as they move through this uncertain environment. Sellers are likely to continue to insist on pre-COVID pricing until they are motivated by or forced by deteriorating operating income. As a result, some firms have put new acquisitions on hold as they wait for the impacts to be reflected in pricing. Every person who is interested in investing in real estate should see this as a time of caution, but one that should eventually give way to opportunity, just as was the case in the Great Recession over ten years ago. The investors that are active coming out of the recession will be those positioned to provide market leading returns.

Market Trends Around the Country

According to the National Association of Realtors, tides are turning in the commercial real estate market.  Money is "starting to flow into commercial real estate".  Loan originations more than doubled from the first half of 2010 to the first half of 2011 (although they are still well below peak levels).  REIT values were at an all-time high.

Office vacancies have drastically declined, more due to the lack of new product than the increase in rentals, but owners of Class A space are giving fewer concessions than a year ago.  Tenants are still kings in the Class B and C markets.  Retail space, which tends to fall with housing, had been very depressed, and is definitely on the way back  now.  Industrial space sales were up more than 50 percent, with the majority being warehouses. Hotels were the lagging performers, with average pricing on sales decreasing and average room rates increasing only slightly.

Multifamily property sales more than doubled from 2010 to 2011, and apartments are the highest performing category of commercial real estate.  Effective rent per unit has bounced back to its peak, paving the way for building more capacity.  Also, rents are on the rise, with vacancies and concessions declining.  When this is combined in New Haven with the country's lowest vacancy rate, we can see this strong market continuing.

All in all, while improvement will be slow and steady, the future certainly appears brighter than the recent past, and should build upon itself as others are drawn to agree.

First Entry

Welcome to the new and improved Pearce Commercial Real Estate Website, and to my commercial blog.  While I have been blogging for a long time, this is my initial foray into exclusively commercial material.

It's always an interesting feeling to be writing in cyberspace.  You have no idea who, if anyone,  is reading what you post.  Nor do you know, unless they contact you, what they think of what you say.  That's my way of saying that I'm going to write about whatever occurs to me that I think might be useful or relevant to the potential audience, and I would be delighted to get feedback from reader about potential future topics.

By way of introduction, Pearce Commercial Real Estate covers most of Connecticut, largely excluding Litchfield and Fairfield Counties.  We do sales, leasebacks, leases, exchanges, and buyer brokerage for industrial, office, retail, and investment property.  We also have a large residential department, and joint ventures in appraisal services, insurance and mortgages.  We see the market from the "boots on the ground" level, and get enough industry material to also get the view from 10,000 feet above the ground.  I will try my best to balance those two perspectives, and hope that you will find this site useful.