Office Market Overtime

CCIMs work long hours managing deals in this struggling sector.

By Matt Hudgins

The credit crunch has reduced office transaction volume to a trickle and factors weighing on the sector are likely to limit deal making through year-end. Asset values have declined nearly 30 percent from their peak, financing is scarce, and downward pressure on office fundamentals is exacerbating the wide gap between bids and asking prices.

It’s a difficult landscape for investment brokers and their clients to navigate, whether they are office buyers, sellers, or developers. In the first four months of this year, property owners put nearly $13 billion of office properties up for sale but only closed $4.4 billion in transactions, according to Real Capital Analytics. Nationwide, sales volume is down 70 percent from year-ago totals.

Perhaps more critical is a dearth of acquisition financing that hampers deals even where buyers and sellers reach a middle ground on price. Conduit providers have ceased to issue new loans due to a logjam of commercial mortgage-backed securities, and life insurers largely have reached the limits of their real estate lending allocations.

Yet today’s market provides opportunities for CCIMs to apply experience, training, and creative thinking to make deals work, says Stan Watson, CCIM, owner of Watson Real Estate in Ann Arbor, Mich. “You can pick lemons off a tree but you have to dig for diamonds, and right now that’s what we have to do,” Watson says. “We have to work a little harder. We have to be extremely creative.”

Just last year, Watson helped a client obtain $5 million in financing to develop a single-tenant office project on St. Joseph Mercy Hospital campus in Ann Arbor. Local lenders expressed interest in the deal but balked at the requested loan amount, so Watson pooled resources from five local credit unions to assemble the necessary sum. The tenant moved into the completed building earlier this year.

“You need to develop relationships and seek out those lenders that are really lending money, such as state-chartered banks, credit unions, or others you maybe haven’t considered before,” Watson says. “I never thought I’d be pooling credit unions, but in a market like this you start thinking what else can I do?”

Done Deals
What enables some deals to close while others founder? Details vary, but brokers say success comes from persistence and having the courage to take unconventional approaches to problems that otherwise would derail transactions.

Brian Andrus, CCIM, owner of Stonebridge Real Estate Co. in Clearwater, Fla., recently sold two office properties, and both required extra effort. In the first case, an office user was attempting to purchase a former automotive service station that had been converted for office use. The buyer lined up acquisition financing from a regional bank offering 85 percent loan to value to owner-occupants.

But before the new investor could close, the bank halted the deal, demanding documentation that the property had been cleared of underground fuel storage. After an exhaustive search, an environmental assessment firm working with the seller tracked down proof that the tank in fact had been removed years before, and the deal closed.

In another recent example, Andrus marketed an office project that required him to spend 40 hours reworking an existing lease to suit a prospective buyer. “Every deal is taking more care and more time,” he says.

Getting Up to Speed
When the credit crunch began, the highly leveraged buyers that fueled bidding wars in 2006 and 2007 effectively were excluded from the market. The few remaining active buyers demand lower pricing to reflect their higher cost of capital, which includes substantial equity and comes with an aversion to risk that must be placated with greater returns.

Throughout most of 2008, buyers and sellers simply disagreed on prices and trading slowed to a crawl while the market worked out corrected pricing based on existing income streams. Commercial real estate values have wilted in that time, particularly those predicated on income growth projections that did not come to fruition. The Moody’s/REAL Commercial Property Price Index showed office asset values in April 2009 were down 29 percent from one year earlier. Real estate investment trust share prices, which are considered a forward indicator, suggest commercial real estate values will decline 40 percent from peak to trough before the market hits bottom.

After more than a year of job losses and economic contraction, declining office fundamentals threaten to eat away asset values. Whether due to companies negotiating lower rates on lease renewals or tenants going out of business and defaulting on lease obligations, many property cash flows have faltered and further reduced the value of investors’ holdings.

“The office vacancy rate is now a little over 16 percent, and over the next six months it will creep into the high teens and maybe crest at 20 percent by the middle of 2010,” says Ben Breslau, Jones Lang LaSalle’s Americas research director. “Then it becomes a matter of when the economy picks up. If the economic recovery takes hold this year, we might see vacancy rates stabilize by the end of 2010.”

As a result of rising vacancy and softening demand, rental rates are flagging and will drop 8.1 percent on average over the course of 2009, the largest one-year decline on record, according to New York-based researcher Reis. Negative absorption this year will range near 70 million square feet, shy of the 100 million sf of negative absorption Reis tracked in 2001, but enough to make 2009 a painful year for the office market.

Buyers Want Bargains
For owners trying to unload distressed assets, speed is critical, says Brian E. Estes, CCIM, president of Prudential Commercial Real Estate in Jackson, Miss. That’s because the property usually is costing the owner money. Setting a price to meet the market also can be a challenge, because a distressed asset often lacks part or all of its income stream. Without income to use in extrapolating value, capitalization rates become irrelevant, so a buyer is more likely to consider a distressed property’s price relative to construction or replacement cost, Estes says.

Earlier this year, Estes helped a bank sell an 115,000-sf office complex after a foreclosure. He found an all-cash buyer who bought the complex, made improvements, and brought in new tenants. In a separate deal, Estes helped a client sell a struggling retail property that had lingered on the market for more than two years, finally moving the asset at a price equivalent to 40 cents on the dollar. “We knew no one would get financing to buy this shopping center, so the first all-cash offer we got, we took.”

Investors waiting to buy at rock bottom prices aren’t waiting for sellers to come down in price, brokers say. They are waiting for sellers to go into default and foreclosure. Owners are unlikely to sell even distressed assets for pennies on the dollar because they still hope to recover their investment. Banks, on the other hand, may be willing to sell at a substantial discount in order to unload foreclosed properties from their portfolios. “A bank is motivated to stop the bleeding,” Estes says.

So far in this cycle, such real-estate-owned sales are few. RCA tracked only 13 REO sales by banks to third parties in the past year. But distress is mounting. The inability to obtain replacement financing for a maturing mortgage or construction loan is a common source of distress for investors. By this definition, more than 525 U.S. office properties, representing almost $18 billion, have fallen into distress since February 2008, according to RCA.

Estes believes a wave of distressed sales soon will break on the investment market and provide investors with tremendous opportunities to snap up discounted assets. He passes along these words of advice, given to him by a banker earlier this year: “If you are an investor and you buy real estate from anybody other than a bank in the next two years, you probably will have overpaid.”

Creating Success
Against this bleak backdrop, how can CCIMs overcome both the national stagnation in office sales as well as the unique challenges of their individual markets? It’s a good idea to start building relationships with lenders who soon will take possession of foreclosed properties, says W. Darrow Fiedler, CCIM, director of KW Commercial in Santa Monica, Calif.

Even after a foreclosure, lenders may be reluctant to sell an asset at a discount right now because that would force them to realize portfolio value loss. This creates an opportunity for CCIMs to help those banks manage their REO properties, keeping them in operation to postpone the need for a sale until the market improves, Fiedler says. Ultimately, CCIMs will be in a good position to pick up the sales listings, too.

Investment advisers can help a property stand out and succeed by taking a comprehensive approach to its marketing, says Peter Kozel, chief economist for commercial real estate service provider FirstService Williams in New York City. That begins with establishing a business plan for the asset in both the short and long term.

“You have to come up with a consistent argument for the property,” Kozel explains. “What is the property’s reason for being? What niche does it have in the marketplace? What kind of tenant does it attract? What’s the outlook for that tenant base?” Today, not just prospective investors but even tenants are asking for details about a property’s capital structure, he says.

Jeremy Kronman, CCIM, executive vice president at CB Richard Ellis in Pittsburgh, agrees that a comprehensive plan of attack increases a building’s chances for retaining or even increasing its value. “We talk about what’s the plan for each individual tenant,” he says. “Today we’re sitting there with the owner and the lenders and talking about what loan to value they want to achieve. We’re not just leasing agents; we are whole-building consultants.”

Financial Footwork
Financing remains a serious challenge, and dependable financing can differentiate a buyer from other bidders on an asset, says David Brightwell, CCIM, vice president of business development at Validus Group in Tampa, Fla. He is lining up funding sources in advance to prepare for future acquisition opportunities. “In this market, the No. 1 offer doesn’t necessarily get taken because the seller will accept a lower offer from a buyer that he knows has the ability to close,” he says.

Government-backed lending through the Small Business Administration’s 504 program provides a good source of leverage for buyers who plan to occupy all or most of a new space themselves, says Steven W. Moreira, CCIM, president of Magic Cos. in Longwood, Fla. “That’s one government stimulus that is working,” he says. “A bank can write a construction loan under 504SBA and have a 90 percent takeout guarantee from the government.”

Yet even this oasis of capital may be evaporating, says Soozi Jones Walker, CCIM, owner of Commercial Executives in Las Vegas. In the past 12 months, banks have increased their scrutiny of 504 loan applicants and will decline those who don’t have a track record of strong financial performance, she says. “If a potential buyer has had either flat growth or a little bit of declining income, they won’t approve them,” she says. “It’s a great program; [504 loans] are just hard to get now.”

In this market of stress and distress, CCIMs must continue to bring all of their skills to bear in order to preserve the value of their clients’ properties and help investors identify assets offering the greatest possible return. Despite the persistent challenges of the market and economy, this is not the time to slack off: The best buys are made at the end of a recession and investors make the most money in a cycle during the first five years after recession, Walker says.

 “There is no coasting, but there are success stories out there,” Kronman says. “When you do your homework and when the ownership, financing, and leasing are all talking, you absolutely can pull off success stories.”
 

Matt Hudgins is a writer based in Austin, Texas. He covers commercial real estate for several publications.

Listen to REIS' Research Director Victor Calanog's podcast on the factors that will contribute to the office market's recovery.

Strong Ownership Bolsters Leasing

The distraught office market offers excellent opportunities for companies to upgrade to new work environments or sweeten the terms on existing leases. In representing landlords, however, the challenge is to provide the right incentives and lease terms to attract and retain tenants without impinging on the property’s potential for rent growth down the road.

Fueled by more than 6.5 million job losses since the start of the recession, the average vacancy rate for U.S. office properties in 2009 already has fallen to levels not seen since 2005 and is expected to deteriorate for another year. The vacancy rate had climbed to 15.9 percent by the end of the second quarter from 13.2 percent at midyear 2008, according to New York-based Reis. Effective office rent fell 2.7 percent in the second quarter alone and was down 6.7 percent from a year ago.

“The office sector is reeling from the huge contraction in demand for space, where you’ve got employers shedding jobs and not needing as much space or going out of business altogether,” says Victor Calanog, Reis’ director of research. “We’re forecasting vacancy to continue to rise through 2010 and peak at 18.2 percent, which will be a vacancy level not seen since 1992.”

Property owners can preserve asset value by protecting rent rolls and income during this critical period. Rather than lowering rents below the market average, landlords may offer an initial period of free rent, tenant improvement dollars, or other measures that reduce the tenant’s occupancy costs. However, landlords should limit the term on any such concessions and avoid locking in lengthy leases while the market is down, says Brian Frank, CCIM, operations manager and senior real estate analyst at Kilby Valuation Group in Gilbert, Ariz.

“A prudent owner leasing properties below market would try to limit the term,” Frank says. “If the market rate is $20 per square foot, the owner might offer space at $15 psf for a two- to three-year term, but he would want to be able to lease the space again when market rates come back up.”

Indeed, office rents have plummeted in markets across the nation and are projected to fall 8.1 percent in 2009 from year-end 2008. That will be the largest one-year decline on record, according to Reis. The drop is likely to be followed by a 5 percent decline in 2010 before picking up steam again in 2011.

Yet a strong value proposition is enabling at least one landlord to buck the downward trend in rental rates, according to leasing expert Jeremy Z. Kronman, CCIM, executive vice president at CB Richard Ellis in Pittsburgh. Last year when CBRE picked up the leasing assignment for 11 Stanwix St., the former headquarters of Westinghouse Electric Corp. in Pittsburgh, the building’s occupancy was 55 percent, and no lease term extended more than three years. Nine months later, Kronman’s team had increased occupancy to nearly 75 percent, with leases averaging 11 years, and increased the building’s average rental rate.

Rather than woo tenants with discounts, Kronman’s team emphasizes the landlord’s financial strength and the fortitude of the building’s new and existing tenants, which include IBM, Health America, and Brunner. A building’s prospects for remaining vibrant and busy are important to tenants seeking a quality, long-term home, he says.

“The tenant doesn’t want to be in a building with a problem,” Kronman explains. “Today many buildings have financing issues, so a building with stable ownership, financing, and tenancy are really important. Ten months ago, that wasn’t even discussed because the tenant never worried about the owner’s financing.”

Medical Office: A Healthy Dose of Demand

Mounting medical needs of an aging population are fueling demand for new and existing professional buildings, and lenders as well as investors are taking notice.

The relatively small healthcare and social assistance sector has maintained its vigor throughout the economic downturn, adding jobs each month for a total of more than 540,000 new positions created in the past 18 months, according to the Bureau of Labor Statistics.

“Employment in healthcare and spending on healthcare services are going to climb,” says Sam Chandan, president and chief economist at New York-based Real Estate Econometrics. “It’s a result of the demographic trend, the aging baby boomers.”

Continued demand for medical office space helps to explain why investors perceive the niche as a safe haven. In the first five months of 2009, 39 U.S. medical office properties valued at $331.5 million changed hands, according to Real Capital Analytics, which tracks office investments of $5 million and greater. Healthcare properties have accounted for 7 percent of domestic office transactions so far this year. “Before 2007, medical office made up between 1 percent and 4 percent of office sales,” says Jessica Ruderman, RCA’s senior analyst. And less than two dozen medical assets have fallen into distress since February 2008, she adds.

“Medical office has always been strong and has commanded generally higher pricing than standard office,” says Brian Frank, CCIM, operations manager and senior real estate analyst at Kilby Valuation Group in Gilbert, Ariz. “It is holding its value much better now. A lot of that is due to the long-term nature of medical office leases.”

Physicians, therapists, and technicians prefer longer leases because of high buildout costs they face: They often install large and costly fixtures and equipment into their spaces, which are difficult to relocate. Health service tenants also like to stay in one spot to provide consistency for their patients.
In the Orlando, Fla., area, the inclusion of medical office units in a large mixed-use project helped to convince lenders to finance the overall construction, says Steven W. Moreira, CCIM, president of Magic Cos. in Longwood, Fla. The Liberty Plaza project will include 88 rental apartments for senior citizens stacked atop 14,800 sf of office space that will be sold to healthcare service providers. The property also is located within walking distance of a hospital campus.

“Medical office is one of the more preferred property types because Orlando is becoming a medical city,” Moreira says. “With all of the hospitals that are here, medical office construction is still a product type that is working.”