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.

Mission Bay Development Slows

The global enterprise software company salesforce.com is withdrawing plans to establish its headquarters in San Francisco’s Mission Bay district, according to a report in the Wall Street Journal. Salesforce.com purchased 14 acres in Mission Bay for $278 million in 2010. It has now decided to move its 3,000 San Francisco-based employees to 50 Fremont – a downtown building that has since become available. Of the 4.4 million square feet of potential office space, salesforce.com had about 1.9 million.

The development of Mission Bay will continue, however, the loss of this project will change the timeline, according to those interviewed for the report. The salesforce.com project will likely be replaced by smaller ones that will eventually fill the unused space. Pier 70, an old shipyard just south of Mission Bay that is expected to be converted into office space, may also witness a reduction in demand and in the speed of its development because of the salesforce.com withdrawal.

The University of California, San Francisco (UCSF) has a research center at Mission Bay and will soon add a hospital. Many biotech companies have also moved to this former rail yard area.

 

Accuracy in Cap Rates

A 2008 paper by Eric Reenstierna argues for the establishment of a standard method of capitalization derivation and he promotes the Appraisal Institute as the organization best suited to set such standards.

Inconsistency in the calculation of net income is the primary source of inaccuracy in cap rate calculations. Commercial real estate practitioners do not always include the same factors in their calculation of cap rates. For example, a broker’s net operating expense (NOE) data for a multi-family unit may not take into account (or sufficiently take into account) vacancy deductions, replacement reserves or management costs.  In the case of a net-leased property, a seller may leave out a vacancy factor (useful for accuracy in the event the tenant defaults), management costs that are not reimbursed by the tenant, administrative costs such as annual accounting or credits for expense reimbursements. The result can be inaccurate cap rates that – when used to appraise a property – will differ from the value derived using comparable sales data. If there is a step rate increase in a long-term lease, an appropriate method may be to take an average that takes into account the step increase and weights the different rates appropriately as opposed to using solely the present rent rate or the future rate.

Reenstierna also discusses the use of survey data to determine capitalization rates. Appraisers turn to survey data to supplement cap rate data derived directly from transactions or they use it as an alternative when no direct data is available. In a price-based survey, he explains that the higher end of the response spectrum is most likely closest to the true market price of a property and in a cap rate survey, it is the lowest cap rate that will determine the market rate as that respondent will likely outbid the others. In the latter type of survey, knowledge of whether or not the respondents have actually made acquisitions at their response rate is important to the accuracy of the survey.

The author compares his proposal for an Appraisal Institute-led standardization of cap rate calculations to the BOMA Standard Method for Measuring Floor Area in Office Buildings to stress the value of having such standards and how it will benefit all those involved in this industry.

Government Purchase

The US General Services Administration (GSA) has acquired Columbia Plaza in the Foggy Bottom district of Washington, according to a report from GlobeSt.com. The government purchased the 511,500sf class C office building from a partnership between Normandy Real Estate Partners and Westbrook Partners for $99.8 million. The State Department has occupied the 15-story building since 1992. The government decided to purchase rather than renew the lease in order to save money, according to the GSA.

Transactions such as this contribute to boosting confidence in the DC commercial real estate market where concern about a possible government downsizing keeps some investors from buying into the market until at least after the presidential elections.