Recovery Extends to Second-tier Markets

The Richmond Times-Dispatch reports that with an increase in debt capital availability and a decrease in the number of high return yet low-leveraged commercial real estate investment options in the “fortress” markets, investors are looking to second-tier markets for opportunities. February sales volume fell year-over-year in Boston, Los Angeles, San Francisco and Washington, but rose in Chicago, Detroit and Seattle, according to CoStar data.

Yields on U.S. Treasuries have increased and as a result, rates on commercial mortgages are higher over last month. This has occurred because investors have more confidence in the economy and are willing to look elsewhere for higher returns. One of the places they are looking is the commercial real estate market, which offers high returns with a lower level of risk relative to other types of investments.

DHS Headquarters Project Faces Uncertain Future

Construction of the 3.8 million square foot DHS headquarters on the west campus of the former St. Elizabeths Hospital has an uncertain future. The reason, according to a Washington Post report, is disagreement about the size of the project and about the necessity and scope of DHS.

Currently, the 22 agencies that report to DHS operate out of more than 40 different buildings throughout the DC metropolitan region. The master plan called for most of these agencies to relocate to new and renovated buildings on the west campus of St. Elizabeths. FEMA would take 750,000 square feet across the street on the east campus. The project was worth $3.4 billion. Washington may gradually complete the project, downsize the plans or cancel it all together depending on the political climate.

The east campus of St. Elizabeths belongs to the District. The DC government is interested in reviving and improving that part of the city and is therefore encouraging private development. Microsoft may open an Innovation Center there and California-based MVM Technologies plans to open an ink-jet manufacturing facility. The city’s master plan also calls for a mixed-use neighborhood with convention spaces, offices and cybersecurity research facilities in that area.

Office Building Classification

Office property classification is a somewhat subjective and unscientific process. Industry participants designate buildings as belonging to one of the three classes listed below. A building does not have to meet all the criteria of a particular class to be considered in that class. Furthermore, each market is unique. For example, a Class B building in one market may be a Class C building in another.

Class A

  • Newest, most technologically advanced buildings.
  • Larger in size (100,000sf and up).
  • Rents are in the top 30-40 percent of the spectrum for that market.
  • High-credit tenants, prime locations.
  • Professional maintenance and management.
  • Luxurious common areas, concierge in lobby.
  • Concrete, glass and steel construction.
  • “Trophy” buildings are often considered Class A or A+. 

Class B

  • Older building designs.
  • May be smaller in size.
  • Second tier/mid-range rents.
  • Mid-size tenants, prime or non-prime locations.
  • Average to good maintenance and management.
  • May have an attendant in lobby.
  • Mechanical systems meet tenant needs.
  • Average to good appearance. 

Class C 

  • Older buildings.
  • Bottom 20 percent of rent spectrum for that market.
  • Target bargain hunting tenants.
  • Limited services, usually no attendant in lobby.
  • Mechanical systems may not meet tenant expectations.
  • Dated appearance. 

Washington CRE Market Stagnates

Jeff Clabaugh of the Washington Business Journal cites a Delta Associates report showing a weak first quarter in the Washington office market. According to the report, net absorption is at negative 1.7 million square feet, compared with positive 1.1 million square feet in the first quarter of 2011. During the same period, sublease activity decreased by 128,000sf and the overall vacancy rate rose by 50 basis points. Some of the inactivity may be due to efforts by the federal government to constrain its growth.

Valuation Methods for Commercial Property

1. Cap Rate Method

  • Cap rate = Net operating income (NOI) / purchase price.
  • NOI = Net income + interest expenses + depreciation.
  • High Cap rates are associated with higher risk and low demand while low cap rates are associated with stability and low risk.

2. Sales Comparison Method

  • Compares subject property to similar properties within the same market area.
  • May correct for unique features in the subject property.

3. Capital Asset Pricing Model

  • Determines an asset’s rate of return – taking into account systematic risk – and compares this rate to the rate of return on low/no risk investment options.
  • Goal is to produce a portfolio with the best possible expected rate of return for the level of risk (see graph below).
  • Slope of the capital allocation line (CAL) = incremental reward to risk ratio.

4. Cost Method

  • Free-market value of land + construction cost of property – depreciation.
  • Cost/value derived while taking into account “highest and best” use of the property and land including zoning factors and other limitations.
  • Often used to value special use properties.

Development Project in Guangzhou

Alex Finkelstein reports for the World Property Channel that developers Guangzhou R&F Properties Co. and Poly Real Estate Group Co. plan to add 18.3 million square feet of Class A space to Guangzhou’s inventory this year. About 90 percent of the new space will be in Zhujiang Xincheng – a zone that Guangzhou’s government earmarked as its new central business district a decade ago.

The vacancy rate in Guangzhou stands around 12 percent and may rise to 25 percent, according to the report. Furthermore, the Chinese economy may not be as robust as before with a projected 2012 GDP of 7.5 percent and the largest trade deficit in 22 years. Nevertheless, the developers believe that the projects will bring jobs and additional investment into the city to support the thousands of workers involved in construction. Over the past ten years, the Chinese government has spent much on infrastructure development and it hopes to turn Guangzhou into a global center for finance and commerce rivaling Shanghai.

Fourth quarter average monthly rent in Zhujiang Xincheng was at $4.09/sf compared with $3.72/sf at Tianhe (Guangzhou’s former central business district), $7.43/sf in Beijing and $6.13/sf in Shanghai.

Surge in Leasebacks

Leaseback transactions are expected to reach a value of $328 million in the Twin Cities this year. This is almost a ten-fold increase from 2010, according to a report in the Star Tribune. In a leaseback, an asset is sold and then part or all of it is leased back. A commercial real estate leaseback provides the company with the option of staying at its current location while at the same time having the flexibility of leasing a different amount of space without becoming a landlord. It allows the company to create liquidity and to invest in other sectors.

A good credit rating makes it easier for companies to enter into long-term lease agreements. The Twin Cities has a large number of companies with good credit and this factor contributes to the surge in leasebacks there but this trend is not exclusive to the Twin Cities. Leaseback transactions are gaining popularity in markets throughout the United States.

1031 Exchange

A brief overview of the Section 1031 exchange rules:

1.  The exchange must involve “like-kind” properties. All properties must be held for a productive purpose in business or trade, as an investment.

2. Within 45 days from the day of selling the relinquished property, one or more replacement properties must be selected. In the case of multiple properties, one of the following rules must be satisfied:

  • Three Property Rule – Up to three properties are selected regardless of market value. Not all of them have to be purchased.
  • 200% Rule – Any number of properties are selected as long as the aggregate Fair Market Value (FMV) of all replacement properties does not exceed 200% of the aggregate FMV of all of the relinquished properties as of the initial transfer date. Not all of the selected properties have to be purchased.
  • 95% Rule – Any number of properties are selected as long as 95% of the aggregate FMV of the selected properties is purchased.

3. The identified replacement property must be acquired by the taxpayer within 180 days.

4. At the close of the relinquished property sale, the proceeds are sent to an intermediary, who holds the funds until the transaction for the replacement property is ready to close.

5. If the investor is trading down, the resulting “boot” –  in the form of net cash received, debt reduction, excess borrowing to finance the replacement property or sale proceeds being applied toward non-transaction costs at closing – may be subject to taxation.

Commercial Property Tax in Iowa

In Iowa, farms are taxed based on production as opposed to land value and residential property is taxed at approximately half its assessed value, according to a report in The Republic. Commercial property, however, is taxed at 100 percent of its assessed value.

Republicans in the state legislature, backed by Gov. Terry Branstad, favor a plan to reduce the commercial property tax rate to 60 percent of the property’s assessed value. Democrats believe that the reduction should apply only to the first portion of the commercial property value. Their intention is to reduce the burden on Iowa businesses, which tend to be smaller while continuing to collect revenue from larger businesses that tend to be from out of state.

The two sides have not yet reached a compromise.

To Buy or to Lease

David G. Hunt provides some factors for firms to consider in deciding between purchasing and leasing commercial property:

1. The availability of capital: Firms should evaluate their capital requirements now and in the near future. Real estate should not take a disproportionate portion of their cash reserves.

2. Opportunity cost: Firms should compare the returns derived from placing capital into real estate versus investing it in other areas of the business.

3. Anticipated growth: A purchase may not make sense if the company plans to sell and relocated within a short time (e.g. less than five years). The upfront expenses of a purchase would remain unamortized and may make the purchase unprofitable.

4. Cash flow analysis: A firm should calculate inflows and outflows during the desired holding period, discounting all funds to its present value and considering market appreciation. The resulting scenarios may assist in deciding between a purchase and a lease.