At the Edge and Stagnation of Valuation

The business of real estate is close to an end. Developing, investing and lending have all halted except for the most secure or distressed situations. An enormous swath of the industry is mothballed like an auto plant in the summer. Just like autoworkers, real estate practitioners are wondering if production will re-open. Lending divisions, development companies, land developers, and acquisition departments are closed until further notice. The biggest fallout is people we have all known for many years that are deciding what to do for the future.

 

There is still a small user business but most tenants are staying put until they can get a better picture of the future. Many companies on survival mode are looking for ways to finance their ongoing operations. Expansion is a distant thought. Industrial Los Angeles is suffering from the transition away from manufacturing to an industrial economy reliant on warehouse and trucking. Without consumer spending, the entire warehouse industry is bringing down industrial property as the remaining truckers seek lower marginal rents to remain profitable. Consolidations are rife as many transportation companies give up their own buildings to contract with the lowest cost 3PL.

 

There are a few cost saving stories as tenants migrate from expensive Westside and LAX to lower rents in better South Bay space. A similar trend occurs with companies exiting Downtown to points east or south. Instead of looking for businesses that are growing, the action is on the shrinking enterprise. Another small area of business comes from Asian companies. As American industry declines, Asian companies are expanding into beachhead opportunities they can exploit with better engineering, finance, and hard work. Hopefully, as finance fails to offer satisfactory positions to the brightest minds, we’ll see a renewal of American ingenuity into other productive fields.

 

In terms of the market picture, those owners who can offer cut rate pricing will do so to fill their buildings. Many rents are now below inflation adjusted numbers from the last real estate recession of the early 1990’s.  Others who are stuck with high debt service are in the unenviable position of feeding the flame in a period of declining pricing. Soon it will only make good business sense to stop paying the mortgage and attempt a bank workout. On average, asking rents vs. asking sale prices are wildly out of whack. 

 

Valuation Stagnation:

 

A common thread talking to brokers is they have no idea how to price property. Sellers are still holding on to the old hope of selling in a market of increasing comps. While these Sellers realize that dream is over, they still benchmark to a User world where rents are not as meaningful as appreciation.  Buyers are looking at pricing from the bottom. They use an income approach assuming the worst will happen. This means a 10% cap on declining rents with large reserves for leasing, T.I.’s, commissions, and vacancies. The difference is almost a gap of 50% and this explains why there are no deals.

 

Unfortunately for brokers, velocity suffers and the lack of transaction volume is exacerbated by the banking mess. While many buyers are salivating over foreclosures to come, bankers are willing to roll over problem loans to avoid taking the hit. As long as there are minimal cash flows, government loans at 0% can help banks play the short term rollover game. Suspension of “mark to market” accounting rules is another reason why non-performing loans are not being recognized.  With many developers on the hook with personal guarantees they have no choice but to play ball and send all the rents and sale proceeds to the bank to reduce their outstanding balance. Another government backstop helps the privately financed bank mergers. As long as the US is willing to guarantee the majority of losses, the new breed of bankers can focus on generating deposits while letting their “bad bank” colleagues engage in the dark-side of real estate workouts.

 

We will see plenty of capitulation on an individual scale. But with all the federal dollars, guarantees, and negotiated sale prices being offered to the most desperate institutions, we’ve created zombie lenders who have no motivation to foreclose and bargain out their properties. However this condition also prevents the lending of fresh money because the underwriting standards banks are using for new loans is the complete opposite they use for their existing, defaulting borrowers. Until we reach a cathartic moment like a GM bankruptcy for the commercial real estate business, there will be no discernible level to promote transactions. We will all be limping along with short term vision.

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