Foreclosure pricing has set the tone in the residential market. While we remain in Foreclosure Land, everyone wants a bargain. This way of thinking bleeds to what was once the “normal functioning” market. Many are anticipating the same will happen in the commercial area. But whether in good markets or bad, the same thing holds true. It’s hard finding deals and it takes ingenuity to make them work. Now more than ever, a tenant is the critical ingredient in almost every purchase.
If there ever was a time for conservative underwriting standards, it’s in Foreclosure Land. We are seeing a return of risk reduction, large deductions for vacancy, and the inclusion of many line items that were neglected in better times. A few of these line items include bonus commission rates, long lease up periods, and substantial T.I. costs. These expenses can easily be 10% of the Purchase Price. Assuming an additional 2 point difference in cap rate (say from a 6 to an 8), the price is reduced another 25%. Factoring in a modest 1% rental growth rather than the previous assumption of 3% annual, could be 15% more off the purchase price. All together, conservative underwriting standards lead to a 50% reduction in the optimistic valuations of the recent past.
While lenders support conservative standards when they are making the loan, these same rational justifications are unconvincing when the banks are selling. Their hands are tied until they can find some way to take the loss. Without more capital or help from the government, the Lender will hope that market conditions improve. REO will often be a discount but not enough to satisfy the most conservative investors. A similar philosophy exists in the non-REO market.
With some properties, Lenders will look to Users because they are not driven solely by financial return. The purchase is not judged by a cap rate but by improvement to the business bottom line. Ideally, the building should have some intrinsic value because it is more functional and better located. However, too many users made the same mistake and didn’t evaluate the purchase carefully but relied on future appreciation. The mortgage needs to be in line with market rents. Otherwise, why buy? A smart User will start from the conservative investor’s mindset and add the value of the features. For instance, increased sales because of location, more productivity because of design, or reduction in labor because of function.
Perhaps the best solution is an investor with a user in tow. This combination marries a business need with the investor’s knowledge. The risk is removed from the investment, more cash can be invested, and loan terms will be improved. The tenant will see better opportunities while getting an investment return for their occupancy. The Seller receives a higher price because they are not heavily discounting an empty building. Coming out of the recession, everyone wants to take advantage of foreclosure pricing. Too many tenants lack the experience and the cash. Meanwhile investors want risk-free prices. Combining forces is a strategic way navigate the delicate terrain of Foreclosure Land.
In a similar vein, some businesses are also looking carefully at distressed Condos. With the large number of condo projects either in default or foreclosure, some local businesses are considering bulk purchases where they can house their employees on a rental basis. This too removes the risk of purchasing empty units and gives employees a better place to live. With many condo prices now at rent levels and lenders unable to absorb all the empty apartments, a business owner can buy an entire building and also give the employees excellent benefits.
We are tracking the commercial defaults very carefully. Investors want to come off the sidelines. Activity on the User side is just staring to stir. Finally, when commercial and industrial property prices start to make sense, we could be back in the real estate business. After the destruction of the last two years and the continuing fall out from the real estate collapse, neither capital, nor grave dancing, nor growing businesses are the answers by themselves. The way out of Foreclosure Land goes to those who can put all the pieces together.