Commercial Real Estate Blog

The SF Chronicle today is featuring an article discussing the trouble San Francisco office market is facing as a result of all that is going on in the equity and debt markets. There are two key takeaways in this article. The first is that we could see a 900 basis point increase in the office vacancy rate in the not too distant future. That is a serious number.

The second thing to take note of is in the last section, where a landlord who seemingly has a tenant in hand is running into trouble securing additional monies from his lender to fund tenant improvements. That is something we have been seeing become more common recently, along with landlord’s bumping up their security deposit requirements.

As a tenant, given the inherent risk in the market, if large security deposits and improvements are involved, it becomes absolutely crucial that non-disturbance agreements be attained from existing and future lenders as part of the deal. Tenants need to have assurance that no matter what happens with the building, there tenancy and investment is secure.

Furthermore, if an increasing number of landlords become unable to fund improvements, that will put significant downward pressure on rents as many landlords will be forced to offset what they can’t provide in TI dollars with a lower rental rate and/or additional free rent to secure tenants.

The governor of the Bank of England stated yesterday that “It’s bound to be the case that there is the possibility of a quarter or two of negative growth”. That would qualify as a recession, though that word is not used. Following on Japan’s release of numbers which showed contraction in their economy, it is clear that commodity and energy prices are taking effect worldwide. In the UK, headline inflation is expected to come in more than twice as high as the 2% target rate, and the latest unemployment numbers reveal six successive months of rising unemployment.

Compounding economic declines with the credit crunch, it is clear that banks are unlikely in a position to relax the strict underwriting practices which have replaced the easy money environment of two years ago. The less visibility that banks and lenders have, the more pressure it puts on commercial real estate since during these times loans will come due and will need to be refinanced. The tough lending environment may result in the need for owners needing to kick in additional equity, which if unavailable, could lead finally lead to the distress sales in commercial real estate so many are eagerly waiting for.

IndyMac Bank (NYSE:IMB) was taken over by the FDIC today as it went under for being under-capitalized. The banks stock which went from $50 down back in 2006 ended at $.28 today. IndyMac is the largest thrift ever to go under in the United States, and the second largest bank to go under.

The FDIC will probably take a huge hit on it and then flip the bank out to an acquirer. Until they find a buyer though, the FDIC is running the show.

The failure comes after their June 30th announcement in which IndyMac said it was ceasing all commercial lending activity.

It is likely that this won’t be the last failure as market conditions continue to deteriorate in many markets. There is over $1T worth of ARM mortgages that will be coming due over the next year or so, and as those loans also turn into junk, more banks will feel the pressure to raise capital to prevent a fold-up.

Shorenstein has acquired a $51.1M mezzanine loan collateralized by McCandless Towers in Santa Clara. Globe St. is reporting that the the debt was acquired at a discount.

McCandless Towers was purchased by Tishman Speyer last July at a cost of $500 PSF ($213M), representing a 4.5% cap rate. McCandless Towers features two 11-story, 210,000 square foot, Class A office buildings anchored by McAfee. The project was completed between 1986 and 1988 and features a 1,400 stall parking garage. The project was built by Swinerton and designed by Hoover Associates.

Shorenstein has been an active buyer of junior debt in primary markets, picking up debt in Washington D.C., New York, LA, and more locally, a $40 mezzanine loan on the Moffett Towers project in Sunnyvale which we wrote about back in October of 2007.

Over the past few decades, real estate investment has become increasingly sophisticated. Large institutional investors and developers have seen the line blurred between traditional investment banking for securities and that for real estate. Everything from the market analysis to the financing of the project has changed.

Investors in commercial real estate often classify projects and assets into various classifications, which we’ll try to explain below. In similar fashion to classifying office space as Class A, B, C, there is no absolute criteria by which an asset is graded, but most investment professionals are able to generally agree on which category an asset falls under. That said, the classifications investors generally hear about are:

• Core, or Core-Institutional: These assets are the highest-grade real estate asset. They are easier to finance, and generally command the lowest Capitalization Rates. An example of a core-institutional investment would be a fully or nearly fully-leased office property in a historically strong office market such as San Francisco or New York City.
• Core-Plus: A Core-Plus asset is an asset which is also high quality, yet one which represents to an investor the opportunity increase the asset’s investment yield through some event. For example, the asset might have some scheduled vacancy or leases rolling over which would give the owner the opportunity to increase rents. Another characteristic of Core-Plus is an asset which could benefit from some upgrades or renovations by which the investor could then command higher rents and improve his return.
• Non-Core: These assets generally fall into the “B” category. An example might be a “C” asset in an ”A” location, or even a Class A asset located in a secondary (”B location”) or tertiary market. These assets are generally overlooked by larger institutional investors, and generally have a higher vacancy rate, and slower rental rate growth, and investors demand a higher Capitalization Rate when acquiring these assets.
• Value-Add: Assets which fall into this class are those where a buyer has an opportunity (that’s the expectation at least) to acquire an asset, and add significant value through a major event. An example of a value-added asset might be one which an investor acquires an older office building, performs significant renvoations to the building’s interiors and exterior to reposition it from a Class B asset to a Class A, and leasing it at higher rates. Another example is an investor acquiring an asset and increasing density, to add value. Value Add is generally the riskiest investment class of those we have discussed so far.
• Opportunistic, Distressed: These assets represent one of the highest levels of risk for a property investor. An example could be a bank foreclosure or an asset whereby the seller is in financial difficulty. Given the condition of capital markets today, many are expecting these opportunities to begin to surface and funds have been setup to focus specifically on these types of investment. An example of an opportunistic deal would be to acquire a note on a property belonging to a troubled seller, negotiate control of the property, and then provide the equity or financing to renovate the property.
• Development, Redevelopment: These types of assets represent those whereby a buyer could acquire an asset which would benefit from a higher and better use. They can either be ground up development, or a redevelopment of an existing site. These assets demand the highest returns because of the inherit risk in both acquiring and constructing the asset, but also leasing and market risk taken on by the investor and/or developer. A local example would be Santana Row. The site Santana Row sits on was formerly a Town & Country shopping center, a single-story, surface-parked retail center. Federal Realty (NYSE: FRT) acquired the property and re-developed into a massive mixed-use project encompassing hotel, condos, apartments, retail, and office.  

The Royal Bank of Scotland’s (RBS) chief credit strategist Bob Janjuah has issued a report to its clients to be prepared for a global credit and equity crash. Bob Janjuah forewarned against last year’s looming credit crisis. According to his report, the next three months will be nasty.

The report includes warnings that the S&P could fall by more than 300 points to 1050 by September. In debt markets, they are forecasting that both the high grade and low grade iTraxx indexes could soar. This index is a European index designed to allow people to trade the “Riskiness” of European debt, with the US having a seperate set of similar indexes as well.

What is key in the report has to do with inflation, the fed pumping money into the market, and what needs to be done about it. All the money being pumped into the market by the Fed is causing headline inflation to increase. Unfortunately we find ourselves in economic conditions which don’t easily allow the raising of interest rates. The economy, both domestic, international, and emerging markets will then be faced with further tightening of credit causing global growth to cool significantly.

The impact on commercial real estate could be significant; you would have the cost and availability conditions of debt to continue to deteriorate, coupled with the fact that risk premiums will have increased in other asset classes. This would suggest a similar jump in expectations for commercial real estate, which translates into higher cap rates and tighter, more conservative underwriting from institutions. Things are trending in that direction, and RBS’s report could suggest that we’re aways away from any reverse.

Wachovia issued a report earlier this month on the state of commercial real estate. Generally speaking, they are bearish on almost all asset classes. Citing a tight lending market, oil prices, slowing demand, and other factors, the anticipation is that the run up in asset prices will continue the reverse which was initiated over the past few quarters.

The report contains a lot of useful data and charts, and rather than paraphrase the details, I’ve outlined the key points below. If you’d like to read the whole report, it is available here for download.

• Traditional Commercial Mortgage Financiers Pick-up Market Share
• CMBS Issuance Halts and About Face
• Nonresidential Construction Set to Weaken
• Property Fundamentals Correction Underway
• Domestic Banks Tighten Lending Standards
• Slowing Economy Puts Pressure on Office Fundamentals
• Industrial Demand Cooling Off
• Apartments Expected to Benefit from Housing Slump?
• Retail Slowing with Consumer Spending

There isn’t much that wasn’t generally known in the report, but the numbers and charts quantify what is going on. The prices are national averages so cap rates, costs per square foot, etc. in the report vary significantly from what assets trade for in Silicon Valley and bay area. Nevertheless, money chases opportunity so any fundamental change in other markets will have an impact on our local market as opportunity costs become to great to ignore.