Category Archives: Investment

Concentration Continues at the Top Tier of Industrial Buildings

The world of big industrial has evolved with fewer and better capitalized buyers. It’s a core group of 15 or 20 nationwide owners that know the markets, have talented principals and to the delight of most sellers, they close for all cash. In contrast, the entrepreneurial developer who played such an important development role in past buying cycles has almost completely vanished from the scene. High Net Worth Funds, REITS, Pension Plans, and the Insurance Companies dominate the ranks of primary industrial investors.  Occasionally, developer partners, seek out capital from the large institutions, but control still reverts to the same dominant group of investors.

Outside of the core investors, there are always a few Users at any given time. Many are international in origin, have large personal wealth and are only looking for one location to house their main business. Because there is no “backside” leasing in a User deal, the industry still favors investors, pricing being equal. Large corporations rarely purchase industrial space today except in cases of unique production facilities.  Non-institutional and older buildings are more wide open but financing is still a limiting factor. Further, with the scarcity of Grade A properties, the definition of institutional grade has been widening to include older and smaller buildings. In other words, competition is still limited to the top tier buyers.

This greater concentration of financial firepower is generally a good development for Sellers of large industrial. There are enough Buyers so no individual can control the market, but each one has strong  closing capabilities. During the vetting, a few bidders often rise to the top for reasons particular to their immediate investment objectives. Unlike in past times, vacant buildings or short term leases are just as desirable as property with long term tenancies.

A limited set of well qualified Buyers eases the sales process if the target buildings fit the mold.  If the real estate doesn’t have any inherent title or environmental problems and the buildings can be categorized as “modern distribution”, a Seller will be rewarded with many high quality offers. The relative simplicity of selling these larger properties is a stark contrast to the typical market transaction.

For instance, leasing is the hard work of the brokerage business. Where selling a quality building is a one-to-many relationship, leasing is one-to-one . Unless the building has some outstanding features, the broker’s work is to call one-by-one, over a long period of time.  Even with all the effort, there have been some unusual recent disappointments with buildings that should have leased but are still empty a year or more later.

The sale of older buildings has its challenges but is made easier because there is not much for sale and many smaller and mid-size company owners desire to purchase for their own personal financial reasons.  But this is a more free-wheeling part of the market than the top tier because banks play a more important role and there is a wider assortment of buyers from which to choose. Finally, older buildings often come with more design and structural problems that take time to correct.

A greater concentration of building owners is becoming the norm.  The largest investment groups have already absorbed many of the most talented players in the business mostly because funding flows to the largest organizations. As this trend continues, other categories of industrial will be absorbed by these growing entities.  Re-positioning slightly outmoded product and rolling up smaller, multi-tenant is the next wave. For now, there are still a fair number of one-off property owners but their ranks are diminishing as the bigger entities grow their experience, relationships and financial resources.

 

Commercial Mortgages Are On The Way Up

 

Many have already seen charts like this one showing a big drop at the end of 2007. It explains the past four years of weak sales. The small uptick demonstrates the recent increase of deals. Since this is 2011 Q3 data, (but released earlier this month), I expect to see more improvements. The same indicators are alive in the market.  A long way from peak conditions but in the right direction. 

Finding Deals In Foreclosure Land

Foreclosure pricing has set the tone in the residential market. While we remain in Foreclosure Land, everyone wants a bargain. This way of thinking bleeds to what was once the “normal functioning” market. Many are anticipating the same will happen in the commercial area. But whether in good markets or bad, the same thing holds true. It’s hard finding deals and it takes ingenuity to make them work. Now more than ever, a tenant is the critical ingredient in almost every purchase.

If there ever was a time for conservative underwriting standards, it’s in Foreclosure Land. We are seeing a return of risk reduction, large deductions for vacancy, and the inclusion of many line items that were neglected in better times. A few of these line items include bonus commission rates, long lease up periods, and substantial T.I. costs. These expenses can easily be 10% of the Purchase Price. Assuming an additional 2 point difference in cap rate (say from a 6 to an 8), the price is reduced another 25%. Factoring in a modest 1% rental growth rather than the previous assumption of 3% annual, could be 15% more off the purchase price. All together, conservative underwriting standards lead to a 50% reduction in the optimistic valuations of the recent past.

While lenders support conservative standards when they are making the loan, these same rational justifications are unconvincing when the banks are selling. Their hands are tied until they can find some way to take the loss. Without more capital or help from the government, the Lender will hope that market conditions improve. REO will often be a discount but not enough to satisfy the most conservative investors. A similar philosophy exists in the non-REO market.

With some properties, Lenders will look to Users because they are not driven solely by financial return. The purchase is not judged by a cap rate but by improvement to the business bottom line. Ideally, the building should have some intrinsic value because it is more functional and better located. However, too many users made the same mistake and didn’t evaluate the purchase carefully but relied on future appreciation. The mortgage needs to be in line with market rents. Otherwise, why buy? A smart User will start from the conservative investor’s mindset and add the value of the features. For instance, increased sales because of location, more productivity because of design, or reduction in labor because of function.

Perhaps the best solution is an investor with a user in tow. This combination marries a business need with the investor’s knowledge. The risk is removed from the investment, more cash can be invested, and loan terms will be improved. The tenant will see better opportunities while getting an investment return for their occupancy. The Seller receives a higher price because they are not heavily discounting an empty building. Coming out of the recession, everyone wants to take advantage of foreclosure pricing. Too many tenants lack the experience and the cash. Meanwhile investors want risk-free prices. Combining forces is a strategic way navigate the delicate terrain of Foreclosure Land.

In a similar vein, some businesses are also looking carefully at distressed Condos. With the large number of condo projects either in default or foreclosure, some local businesses are considering bulk purchases where they can house their employees on a rental basis. This too removes the risk of purchasing empty units and gives employees a better place to live. With many condo prices now at rent levels and lenders unable to absorb all the empty apartments, a business owner can buy an entire building and also give the employees excellent benefits.

We are tracking the commercial defaults very carefully. Investors want to come off the sidelines. Activity on the User side is just staring to stir. Finally, when commercial and industrial property prices start to make sense, we could be back in the real estate business. After the destruction of the last two years and the continuing fall out from the real estate collapse, neither capital, nor grave dancing, nor growing businesses are the answers by themselves. The way out of Foreclosure Land goes to those who can put all the pieces together.

INFILL LAND

 

 

In the competition for industrial real estate investments, more institutionally backed buyers are dabbling with infill land, but have not yet found the formula for success. Infill sites are considered non-traditional investments because they take more effort to understand and come with substantial risk. Large buyers can not make as big an investment in infill as when they purchase a portfolio of buildings. For this reason, and until institutions learn how to roll up these non-core properties, there is still a great opportunity for smaller entrepreneurial buyers to distinguish themselves as experts in the field.

Once, only builder/developers sought these parcels for immediate speculative development. Now, with the escalation of construction costs, spec development is generally unaffordable. Land buyers are toying with new strategies that include build-to-suit, land-banking, zone changing, and other exotic plays. One industrial REIT uses “pre-sales” to obtain finished building prices with no more than an open escrow and a site plan. Another company controls many key industrial sites throughout downtown that are on the edge of densification and growth. One developer has a lucrative niche by delivering custom buildings at ever higher prices to Asian users. Some simply scour the region for any sites where they can achieve lucrative up-zoning entitlements or develop for users they have in tow, like markets, drugstores and big box merchants. While each one of these strategies can be successful on their own, there is not enough of these opportunities to build an institutional-sized business.

However, infill land is still for professional investors. It takes experience to analyze alternatives. Significantly more money is required because lenders want cash flow to cover the loan. Delays can mean land will not rent for long periods of time. There are often zone changes, public hearings, at-risk deposits and other entitlement challenges to achieve results. Most non-professionals lack the skills and hiring professional talent will eat up profits. The complexity and uncertainty of land limits the competition from “trade” buyers and “mom and pops”. There is also considerable “on-thejob” learning as nuances become clear about use, traffic counts and densities, only after the deal is underway. The surprising thing is that even the most seasoned real estate investors are amazed at the multiple returns that can be achieved or how big the losses can be in the land game.

Land is a versatile and fluid investment from the time it is purchased and even through the life of the holding period. Landowners will see a myriad of options because until improvements are constructed, there are always new possibilities. Land leases, flips, different development scenarios, and unexpected uses are a few of the alternatives that will arise. If land can be successfully held and managed over a long period of time, landowners will receive high rates of annual return with appreciation amounts that greatly exceed the purchases of buildings. It is one area of the business where outsized returns are available for skilled professionals.

Added Value Property

 

Creative solutions to problem real estate are the domain of value added deals. These are buildings that after they are redeveloped will increase cash flow and operability. The simplest examples are adding more square footage to an underutilized land area or subdividing the building for smaller tenants at a higher per foot rent. Because building new is so costly, there is more attention being paid to reconfiguring older property.

As business changes, buildings need to adapt. The new breed of companies in the Trade Triangle – the area between Downtown markets, the Harbor and LAX – want convenience to labor, transportation and talent. These businesses are small, fast, and ethnically diverse. They trade and source on a global scale. Their products and services are  information laced and branded; technology is a key component. Speed is a must. Close-in locations are required for physical interaction with customers, suppliers, and employees. A lot of the industrial building stock is left over World War II and later. These buildings served a different purpose than what is needed today. While many teardowns exist, the high cost of new construction makes reusing existing more economic sense. On a limited scale, a few developers have created some very successful prototypes, most notably in Culver City. Now the concept is spreading through the rest of Los Angeles.

Lighting, landscaping, additional windows, open offices, outside areas, new demising walls and flexible design are a few of the minor improvements. Total reconstruction will be the next stage of reuse. Buildings will become places instead of locations. In many cases these buildings will no longer serve traditional industrial purposes. Areas near cultural amenities like Asian influenced Gardena, Hispanic inspired Pacific Boulevard, or Downtown adjacent will have the most appeal. Creativity, lifestyle, bonding and deal-making are large components for new business models.

Sometimes these buildings are listed. Mostly they appear on quietly traded channels like a broker’s private mailing list or party-to-party direct deals. The computer multiples may be a limited source but it’s overwhelmingly a vehicle for user sales and leasing, not value added investor deals. Many of the best buildings are held by a fairly small, sophisticated group of investor developers and their advisers who truly excel at the real estate business. Mostly, it leaves intelligence, hard work, and a little luck as the primary method for finding properties to add value.

There are tools that the experts use. Financial models, site plan studies, extensive re-construction estimates, and market studies are a few. Each lease, credit, dimension, improvement, and repair is negotiated and scrutinized. Finally when owned, the best examples will be well managed properties with new signage, shared loading, good space dimensions, amenities, common areas, maintenance, and location. For all but the most seasoned professionals, the value added proposition is difficult because extraordinary skill and patience are required. Of course, the result is a testament to the deal maker. And for the experienced real estate person, the achievement is equal to the financial reward.


Valuation

 

 

 

In many cases traditional methods of valuation – comps, income, and replacement – are no longer guides for pricing property. Sale prices often exceed most traditional justifications. Properties sell with cap rates that are below mortgage rates so the buyer is already starting in a negative position.

Unless the buyer can add value quickly or factor in appreciation, these are not good financial purchases on paper. The shrewd economic justifications only become clear once escrow has closed and the property has been put into use. Here are a few explanations: Los Angeles is a global crossroads and some properties have international dimensions. These properties are not compared to comps locally but internationally

This is especially true if the Los Angeles site is meant to fill a link in a global chain for distribution, production, or sales. In that regard, what some consider overpriced may be a bargain, especially if you include foreign exchange rates. Other locations are analyzed by the sales they generate. Retailers or quasi-retailers value the site in part by traffic and the amount of goods that can be sold. Many industrial brokers and owners miss the retail component of their building. Los Angeles changes so fast that unless you have a retail eye, it’s easy to miss the demand caused by an expanding population.

Los Angeles has a number of micro markets for trade and ethnicity where pricing is higher than the rest of the city. Examples include several downtown markets for merchandise and a wholesale district near Vernon Avenue for “cash and carry”. There are many ethnic communities that cater almost exclusively to people from one foreign country. Real estate prices increase closer to the center of these communities, but only an insider can discern the difference. Zoning adds another dimension. One simple example is how an old industrial site quadrupled in value when the city changed its zoning to residential. As all cities face housing constraints there continue to be enormous increases in value due to zone changes. Land values around redevelopment areas also exceed market conditions.

Finally, professional investors have a second sense when it comes to recognizing potential. Some use patient money with a long horizon. Others use proceeds from past deals. Some take calculated risks based on many years of investing and developing. Key parcels are particularly intriguing because the buyers understand the extra value associated with these properties. Basic underwriting is still fundamental. But buyers who use traditional methods to value real estate will be at a loss compared to those who have a breadth of contacts and experience to understand very local markets and new product types. As Los Angeles continues to grow, buyers of property will need to take greater leaps from fundamentals if they want to continue investing. While real estate cycles may signal bargains from time to time, the overall demographic nature and the intelligence of shrewd investors will be a constant.

Expolding Land Values

 

n my past few newsletters I discussed the enormous potential for land. These days, older property is being purchased for the underlying land value. The major impetus is the evolution from single story development to multi-story. Use of air rights increase the value of land in areas that have never experienced mid rise development. The proposition is obvious in dense urban areas like Pasadena, Downtown Los Angeles, Anaheim or West LA; however, mixed use is expanding throughout the entire region.

While there are entitlements to obtain, returns are substantially higher than common low cap rate investments. Plus there are often interim uses with existing buildings or outside storage to obtain reasonable current cash flow. Suburban tract development and big box industrial are not going away. However, in close-in and transitional neighborhoods, more creative developments are needed to fill urban demand. Partly this is a reaction to freeway congestion and more options for public transportation.

Also, new zoning ordinances are being adopted to create more housing units. Almost every municipality in Southern California, and there are 187, has a planning strategy that includes smart growth, especially in their older downtowns and traffic corridors. In these instances, land values can increase exponentially with creative developments

Another changing condition is the ratio of improvement costs to land value. As buildings age and become obsolete, the contribution of the improvement becomes less as the value of land increases. In other words, where land values may have doubled or tripled, construction costs rise on a fairly predictable linear manner (although much sharper recently). This helps explain the prevalence of teardowns.

In most urban infill locations that have a nearby residential or commercial component, land is valued with consideration of its development rights. If possible, industrial users are advised to fit their business in the pathway of growth. While many of these buildings suffer from various degrees of obsolescence, entrepreneurs have the ability to be more creative with their occupancy. By making accommodations, owner/users can capitalize on running their business in a potentially rewarding location.

Still, the average Buyer needs to beware because every purchase comes down to developing a viable project. While creative land use has greatly pushed values, buying too early, or in the wrong area, will lead to disappointment. Plus, there is now a backlash in many cities. The concern for losing industrially zoned land is becoming more vocal.

Enterprise Buyers

 

While many investors complain about a lack of deals and high pricing, others see nothing but opportunity. One difference in perception is risk tolerance. Another is a reluctance to embrace new development models. But I think the biggest factor in the vision discrepancy is the nature of their organizations.

Enterprises are better positioned to uncover deals because they simply see more opportunities. By enterprise, I mean an organization devoted to purchasing and developing investment real estate. While this may seem obvious, the majority of the real estate market is made up of individual investors, users, and trade buyers who operate at a relative disadvantage because they lack enterprise resources. Interestingly, it’s not necessarily size or type of structure that is the determining factor, but a disciplined approach to sourcing and operating property. Many small enterprises are extremely effective because they work within a larger network and command useful technologies. Enterprises have strategy, focus and can match their resources accordingly.

Enterprises work with a business plan based upon a market need or a strategic advantage. For instance, some enterprises have an advantage in construction expertise, tenant relationship, a capital source, or simply vision. Enterprises will make their own markets and create their own deal flow. In many cases, enterprises already know which properties will fit their model and it becomes a matter of process.

Technology has greatly changed strategic execution. Googling, internet mapping, and online title records help identify prospects. Smart phones, digital cameras, and internet communication give immediate information and access.

Enterprises are better suited to use new technology to meet their goals. For instance, one enterprise buyer has equipped me with a database that I access on my handheld computer when I am in the field. This provides focus and real time communication.

Enterprises also differ from “end-user” buyers because they invest in people, relationships and systems. A typical enterprise includes senior real estate experience, access to finance, and perhaps the most significant – the ability to stick with a plan. It is still a relationship business and the enterprise is able to get its message out to more people.

Should individual buyers devote the same resources as the enterprise buyer? It truly depends on their perspective. But without building an enterprise model, it will impossible for individuals to compete for “deals” on a regular basis. Luckily, for all smart investors, there are always opportunities to have a balanced portfolio that includes rent growth and appreciation to make the non-enterprise buyer welathy.