Commercial Real Estate
Date October 2015
- Among the property sectors, retail experienced the largest cap rate declines with Class A power centers having compressed the most over the last year
Commercial real estate outlook mixed: U.S. vacancy rates in office markets declined by Q2 2015, settling at approximately 13 percent overall with Central Business District (CBD) vacancies at 11.6 percent, primarily due to social and demographic trends attracting millennials and others looking for appealing live-work environments. U.S. gross average asking rent has increased by 3.6 percent year-over-year in Q2 2015, according to the major commercial real estate services providers. Major leasing activity was provided by the high tech and financial services sectors, but firms continue to be conservative when taking on new space with emphasis placed on more efficient space layouts and consideration for telecommuting. The most notable growth and new construction activity is still limited to the top major markets, consisting mostly of major coastal cities.
Industrial real estate vacancy is 6.6 percent overall in the U.S., spurred on by user demand and shrinking supply in both core distribution markets and key secondary markets. Design/functionality of this product type and its location within its respective market are key contributors to the level of desirability. Overall rents have grown nearly 3 percent year-over-year in Q2 2015.
The retail real estate market continues to have diverse recovery with top tier “A” properties gaining strongest demand and pricing. Less favorable properties languish, and numerous centers are under redevelopment, especially those with Big Box vacancies that need to be reconfigured to achieve tenancy. Retailers continue to try to reinvent themselves via changes in their store configurations, sizes, store count, and logistics. U.S. vacancy of approximately 11 percent remains for community, neighborhood, and strip centers, and overall rent growth improved by approximately 1 percent year-over-year. Although mall traffic has continued to decline, lack of new construction with only redevelopment in essentially the “A” rated malls has held U.S. regional mall vacancy at 7.9 percent for Q1 and Q2 2015. Asking rents continue to grow at approximately 2 percent per year. The gap between “A” rated and “B” rated malls is ever widening, however, and the balance of the other categories continue to struggle with ultimate re-use or demise.
Competitive commercial real estate sales: Income generating real estate across all sectors remains the buyers’ preference. Capitalization rates are a function of property location, environmental condition, tenancy creditworthiness, and prospect of continued occupancy, remaining lease term, and level of landlord favorability in lease clauses. “The stronger the NOI… the stronger the buy”– especially considering capital markets’ low interest rates and yields on other products. There is so much money available that has to go someplace with buyers chasing the same product, producing capitalization rate compression rivaling pre-recession levels. Demand is greater than supply, so many have to settle for remaining product availability, the quality of which may not warrant the compressed capitalization rate required. But, whether foreign or domestic capital, that money has to go someplace. Risk of going “upside down” is inherently greater in those lesser quality deals.
Among the property sectors, retail experienced the largest capitalization rate declines with Class A power centers having compressed the most over the last year. Excepting a few prime markets that maintain the strongest investment performance, including New York, San Francisco, Los Angeles, Miami, and Boston, it is reasonable to assume that capitalization rates have now plateaued, generally at record lows. Experts agree that sustainability at these levels is less likely over the long term as the economy improves and interest rates increase. So value increases need to come from income growth.
Given the current competitive environment for existing income generating properties, many yield oriented investors have again targeted value-add opportunity acquisitions of vacant and partially occupied real estate as well as redevelopment opportunities, mostly in the retail and industrial market sectors. Location and traditional real estate fundamentals apply in analyzing targeted viable acquisition candidates, given a buyer’s risk involved with initial investment carry, marketing and retrofit costs until projected income generation can be achieved. Unlike existing income generating properties, a buyer is not acquiring existing cash flow. It has been Gordon Brothers’ experience, with few exceptions, that larger value properties/portfolios garner much more interest than lower value assets, given the minimum deal size requirements of many value-add investors and funds. By way of example, Gordon Brothers recently received spirited value-add investor activity in our $40 million portfolio sale of former vacant RadioShack Industrial Properties in Ft. Worth, TX and Northern CA on behalf of the Debtor in Q2 2015.
Lease sales: Although activity of tenant lease sales through assignment in bankruptcy is only a small fraction of what it was in the past, it still remains in the supermarket and drug store sectors. Purchasers remain strategic operators and landlords in some instances. For strategic users, traditional store openings are very costly and time consuming. Lease acquisition from a similar user is a much faster way to expand into or in-fill within a particular market; such acquisitions are much more of an “enterprise buy” of the business sales history/potential and customer base rather than an economic purchase of a rent spread. A current example of this is the sale of the A&P Supermarket store leases in the New York-Philadelphia Metropolitan area.
Lease mitigation/tenant portfolio restructuring: There is frequent news coverage about certain retailers struggling within their categories, needing to downsize their store count, reconfigure their footprint and/or restructure their occupancy costs and lease terms in order to survive. Natural lease expirations may not be enough to address these issues. Tenants try to mitigate these liabilities with hired consultants through lease terminations and rent renegotiations. When the recession started, there was a wave of this activity and landlords were more receptive as they needed to maintain occupancy levels. But this has become increasingly more difficult as the economy improved. Lenders on secured landlord properties have become more reluctant in allowing landlords to make lease concessions and/or terminations. Mitigation within bankruptcy or with the threat of bankruptcy may hasten greater leverage than outside-of-bankruptcy, but ultimately it comes down the motivations of the landlord parties at the time. Lease mitigation remains an important part of Gordon Brothers’ real estate offerings to clients. Each client assignment is an individually developed mitigation program sectioned by landlord with store-by-store lease review and direct person-to-person negotiations. Hiring advisors with deep market knowledge and the capabilities to resolve case-by-case circumstances at the store level is critical to successful client outcomes.