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COVER STORY, MARCH 2010
DISTRESS SIGNALS
The West finds itself again in a leading role, although this time in a less positive category.
Jim Clark and Kurt Rosene
Distressed commercial real estate in the United States has reached a record $180 billion, according to Real Capital Analytics. Moody’s Investors Service notes that the overall values of commercial properties have fallen 42.9 percent nationally from their high in 2007. The national office vacancy rate is expected to climb to 18.5 or 19 percent by year-end 2010 thanks to the 8.4 million jobs that have been the casualties of this recession. Nationally, commercial mortgage debt exceeds $3.5 trillion, according to Mortgage Bankers Association data. This translates to a surplus of highly leveraged space that will require prudent workouts to satisfy banks and borrowers alike.
The West is saddled with the largest value of distressed and potentially troubled assets and is in the poorest condition when compared with other regions, notes Square Feet, a commercial real estate blog. The region is suffering the largest decline in asking rents, the lowest level of leasing activity, the highest level of available sublease space, the most landlord concessions and the highest vacancy rates.
The following city snapshots provide a view into the troubled state of commercial real estate in the West and the implications for the region as a whole.
Las Vegas
With $17.7 billion of properties that are delinquent, in default, bankrupt, foreclosed or otherwise owned by lenders, Las Vegas is dragging down the region. That figure comprises nearly 10.5 percent of the city’s 37.5 million square feet of office space (the 520 million-square-foot Manhattan market reported the second-highest amount of troubled properties at $12.3 billion as of November).
A significant decline in tourism, rising unemployment and stalled projects are adding to Las Vegas’ woes. At the end of 2009, Las Vegas reported a 19.5 percent vacancy rate with 7.5 million square feet of office space standing empty. Real Capital Analytics puts Las Vegas in first place nationally with 37 percent of its commercial properties in distress. The recession is stalling projects and preventing developers from finding tenants to fill their space, pushing vacancy rates to record levels for office, industrial and retail, while rents decline to the point where landlords are struggling to pay their loans.
Las Vegas’ 98.7 million-square-foot industrial inventory, for example, has a 14.1 percent vacancy rate, even though landlords are offering free rent, generous tenant-improvement allowances and significantly reduced lease rates. Banks will sell the properties they are forced to take back at bargain-basement prices, though market volatility and a lack of comps make it difficult to accurately evaluate the asset’s true value.
Phoenix
At the close of 2009, metro Phoenix had 58 million square feet of excess office, retail and industrial space. Market analysts believe the oversupply will get worse before it improves, with commercial foreclosures unlikely to peak before 2012. Realpoint LLC reports that more than 10 percent of total CMBS issuance in Arizona is delinquent, with Phoenix reporting the highest rate. The December 2009 report shows that 139 loans totaling $1.15 billion are delinquent in Phoenix. That’s 4.087 percent of Phoenix-area CMBS and 10.631 percent of commercial properties in the MSA.
Overbuilding, declining property values and a lack of refinancing options have created a steady flow of distressed commercial properties. Yet even the most pessimistic analysts agree that these conditions will ultimately position Phoenix as an extremely attractive city for corporations that want to relocate to markets that offer cheaper operating and living costs than, for example, Southern California. Office vacancy rates in metro Phoenix stand at approximately 25 percent.
More than 1 million square feet of industrial and warehouse space became vacant during the second quarter of 2009 alone. Industrial vacancy rates across Phoenix totaled approximately 17.4 percent during the third quarter. With the glut of available space, the average industrial lease rate dipped about 15 percent to 56 cents per square foot per month.
Los Angeles
With $1.1 billion in distressed properties, Los Angeles further demonstrates the western states’ troubled status. California has $4.6 billion in distressed assets, accounting for approximately 4.3 percent of the state’s total commercial square footage and three percent of CMBS. Los Angeles’ 190 million-square-foot office market shed 4.8 million square feet of occupancy during 2009, sending the vacancy rate to 16 percent. Tenants seeking space can lock in opportunistic rents, particularly with leases on large square footages. Renewals dominate the market, a sign of stabilization rather than growth.
Los Angeles’ nearly 1 billion-square-foot industrial market ended the year in a stronger state as reduced rates of negative absorption indicate that activity should be on the upswing soon. Even though the vacancy rate is just 3.3 percent, there is downward pressure on pricing because of intense competition from lower-cost locations such as California’s Inland Empire, Phoenix and Las Vegas.
Denver
In the Mile High City, the office market vacancy rate fell to 14.8 percent in the third quarter when positive net absorption totaled 608,160 square feet. With just $250 million in metro Denver commercial real estate property sales this year — the lowest on record — buyers are seeking value-added opportunities. They want to buy properties cheaply, renovate and re-tenant them. While owners currently have little motivation to sell, activity is expected to pick up and there will be attractively priced properties for buyers with cash. Activity between property classes will stabilize through 2010, with rate spreads close to normal by year’s end.
Denver’s 215 million-square-foot industrial market reported a fourth quarter vacancy rate of 9.7 percent, a result of the struggling retail sector and grocery giant Albertsons’ departure from the market. Once leasing activity improves, transactions will take longer to conclude because of the diversity of available choices. Rental rates have fallen by more than 7 percent as older buildings and mid-sized distribution spaces are engaged in a price war for the limited supply of tenants.
Seattle
Real Capital Analytics ranks Seattle as one of the nation’s least distressed commercial markets; it may be one of the first to recover. Markets are ranked by distressed real estate as a percentage, which is calculated when comparing the dollar value of distressed properties to sales volume between 2005 and 2008. By this measure, just 3 percent of Seattle commercial real estate can be considered distressed. Still, Seattle’s 88 million-square-foot office market reported an 18.1 percent vacancy rate at the end of 2009, the second highest in the city’s history. Although asking rates are flat, there is an abundance of underperforming real estate in the Seattle area that can be purchased at deep discounts by investors with cash.
As the Pacific Northwest’s primary port, Seattle’s 162 million-square-foot industrial market and 10.2 percent vacancy rate puts tenants in the driver’s seat as lease rates decline. Rents currently average in the mid- to low 30-cent range per square foot per month. Although only 816,000 square feet of distribution space was delivered in 2009, large-scale speculative development will not occur in Seattle until 2011. The volume of investment sales will rise because of the attractive pricing.
What Happens Next?
The good news for the West is that industry experts believe that investor capital will slowly begin returning to commercial real estate markets towards the end of 2010, with cash investors seeking quality and credit-worthy assets taking the lead. The current high vacancy rates and falling rents present generational opportunities for investors to purchase at or near cyclical lows. Properties classified as A+ will sell for what in ordinary times are Class B prices.
Debt markets eventually will rebound, but will remain below normal standards due to unprecedented de-leveraging. Lending will be conservative, costly and given only to those who have solid relationships with banks. REITs, hedge funds and private equity funds are likely to take the lead and provide loans to distressed borrowers, though the price of that financing likely will be at a premium.
Sales of office, retail, multifamily and industrial properties could exceed $100 billion in 2010, more than doubling the $45 billion projected for all of 2009. The increase would be the first year-over-year gain in investment-sales volume since 2007 when it rose 32 percent to $439 billion. In 2008, volumes plunged to just $133 billion. Many investment managers are raising capital to take advantage of the opportunities to come.
Jim Clark is principal of Alter Asset Recovery, and Kurt Rosene is a senior vice president of The Alter Group.
TOP 5 THINGS YOU, THE TENANT, SHOULD KNOW DURING THE RENEWAL PROCESS
Due to the current economic climate and withering demand from office tenants, landlords are seeing vacancies skyrocket in their buildings. Many tenants are downsizing, moving out and closing their doors in record numbers. Moreover, since landlords’ operating income has taken such a hit, refinancing options are scarce, which may further jeopardize ownership of buildings with maturing or adjustable rate loans. These conditions should give tenants the distinct upper hand in negotiations with landlords, but when it comes to lease renewals, landlords are still stacking the deck. Here are some helpful tips to increase your odds of negotiating a successful lease renewal:
1. Quantify, quantify, quantify — Data is essential when considering a renewal. How vacant is your building? How much are other tenants paying? Are any other tenants downsizing? How many years has it been since common-area improvements have been made? If you don’t know what the suite next door is paying, how will you know if you’re being offered renewal terms 20 percent higher? Talk to real estate professionals, neighboring tenants or others in your network. This is one of the most important decisions to your company’s bottom line — don’t leave it to chance or gut feelings!
2. Leverage from thin air — The process of renewing a lease is the same as relocating. Even if you intend to stay in your space for the next 20 years, make sure to tour the market and request proposals from other buildings to ensure that your landlord knows that you are seriously considering a move and that he or she needs to compete for your tenancy. Who knows, in creating this negotiating leverage, you may end up finding an opportunity that better suits your business!
3. Don’t show your hand — No one outside your real estate department or management team should know your intentions regarding your office space occupancy. Landlords have a team of people who are responsible for keeping their ears to the ground regarding your decisions: brokers, asset managers, property managers and even day porters. For example, if your receptionist has proprietary information and tells the property manager in passing, “Oh, we’re not going anywhere!”, any negotiating leverage you’ve built has now been dissolved. Loose lips sink ships — and your chance at leverage in negotiations with your landlord.
4. Address it early — While some may think that 6 months is enough time to renegotiate their lease even if they intend to stay in a building, in terms of lease negotiations, it is much too short of a time line to realistically relocate and, therefore, tips the landlord to your intent to stay put. To retain the utmost flexibility, tenants should begin mulling decisions about their space at least 12-18 months prior to expiration. This allows the tenant to not only explore other options, but also to capitalize on any current vacancy dilemmas the landlord may be facing, which may result in lower rents and more flexible options. Your business isn’t static, why should your real estate be?
5. Don’t get caught without representation — Landlords rely heavily on their brokers and have a singular goal: to keep their buildings full no matter the cost to the tenants. Shouldn’t you have someone working on your behalf to level the playing field? A tenant broker can be extremely helpful with not only providing vital market information, but also in creating the negotiating leverage necessary to convince the landlord that you’re serious about relocating if you can’t come to reasonable terms on a renewal. A tenant who contacts his landlord directly to express a desire to renew its lease is essentially showing all of its cards and telling the landlord that it doesn’t need to compete for the tenant’s occupancy.
— T.D. Rolf is a vice president and co-branch manager at Studley in San Diego. |
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