After the housing bust, federal bailouts, stimulus package, and fight over extending the Bush Tax cuts, there have been rumors that trouble in the commercial real estate market would be the next major economic event. Some said that refinancing in the mid- to late-2000s, prior to the crash (to cover highly inflated purchase prices), was coming due. And with corporations dumping real estate and consolidating their portfolios, a slew of buildings would be turned back to the banks. This would create another set of toxic assets on balance sheets with detrimental repercussions, potentially leading to a double dip recession.
To some extent, keys have been returned on many buildings, available sub-lease space has been plentiful, and real estate portfolios have been consolidated almost non-stop since 2008. But the hysteria and impending sense of doom has ended. So what happened? Is the end as near as we once thought?
In short, that's not likely. Instead, we have found a new normal in commercial real estate that is not nearly as severe as predicted.
The New Normal
But why? For starters, deals still happen in a recession. Leases expire and are renewed. Landlords have dropped rental rates and added free rent and major work letter concessions. Buildings age and need maintenance, and companies move to more modern or efficient facilities to accommodate changes in business practices and technology. Many states and municipalities pushed business incentives when possible to business retention policies to aid strategic projects.
At this time last year there were very few toes in the water. A bleak 2009 rolled into a 2010 that felt of great malaise (to borrow a term from our last recession) mixed with high unemployment, impending inflation, and low consumer confidence. In 2010, people looked around, but barely outside of, the most pressing and immediate needs within their portfolios.
But 2011 has a different feel. Caution still characterizes the real estate market, but now it seems that there are enough toes in the water that the pool is getting crowded. Things are more positive than many perceive, and competition for space is returning in some instances.
Driving Recovery
Companies are sitting on significant piles of cash, a positive note. Retooling, new operations, and business expansions have been on hold for the last three years. Cost management and headcount reductions - not new market opportunities - have led profits and cost savings over the past several quarters. But now people are getting off of the sidelines partly because they must, as leases expire and machines and buildings require maintenance. The trend is also due to company cost controls that have reached their limits in many budgets. For many companies operating with skeleton crews, budgets can't be trimmed any further.
Mergers and acquisitions activity is gaining traction as executives use acquisition of new businesses as a leading way to grow the bottom line. With valuations down and money still relatively inexpensive, M&A activity will likely drive 2011 real estate transactions. How does that affect the real estate market? Consolidations. As companies are put together and pulled apart, redundancies must be eliminated to justify purchase costs to shareholders, driving transactions at a minimum. Cherry picking facilities within combined portfolios is a major activity, and acquiring additional space or retrofitting and rebuilding at those sites is driving many site selection decisions.
Lower cost real estate alternatives within the portfolio, if they have not already been utilized, will remain a key factor in lessening operating costs. Relocations to cost effective locations also generate activity. This still drives the expansion of manufacturing activities in the Southeast and Southwest.
Old-fashioned opportunism is also driving the market these days. Proactive leasing tenants are extending existing leases to capture lower rental rates while extending the term. While this helps tenants reduce operating costs by buying cheap, it simultaneously gives landlords certainty in showing their lenders that their buildings can be financed, remortgaged, and have a strong cash flow. This is increasingly the case in the Northeast, where activity is off of its rental rate highs. Vacancies are not as high as expected two years ago in central business districts. Both sides of the table win in these transactions, and both are buying certainty and cost control.
On the entrepreneurial side, many owners and speculators are returning to the market by buying the notes on buildings at significant discounts, presenting new tenants with deep rental discounts. This has been a trend in several Northeastern suburban markets, especially in Long Island, New York.
Accounting Changes
Proposed changes to accounting rules will turn expense items like leases into liabilities on a balance sheet. When first proposed a year ago, some said this would dampen the commercial real estate market. As tenants sought to avoid hundred million dollar liabilities on their balance sheets, it's expected that they would seek to either take short-term leases or alternatively buy buildings. The current purchasing of buildings is a refreshing sign, as it also drives transactions, commissions, fees, new taxes, and salaries. Companies hoarding cash for the last two years find investing in a physical structure a safe bet and a conservative choice going forward.
This has given many in the commercial brokerage community and existing landlords cause for concern, as they speculate that lease terms and values will decline. But not every tenant is equipped to be, nor wants to be, a landlord. Thus, deals will still happen. Secondly, the major accounting firms are already seeing compliance and reporting for these new rules as a boon, like Sarbanes-Oxley once was. They are preparing their audit departments to account and bill for this.
So the real concern is the effect this will have on a landlord's ability to finance if terms decline from a standard 10-year lease. This will alter deals in form, but is unlikely to stop them or materially change the business.
Some locations are seeing the decline in property tax rates and costs as an economic advantage. In the Northeast, rental rates have dropped significantly from 2007 highs. Many companies, for the first time in decades, are seeing relatively affordable real estate costs, but stagnating labor rates. Does this make up for other cost factors like higher tax burdens, utilities, and other site selection factors? Not entirely. But it is a silver lining for landlords, brokers, real estate directors, and economic development officials. Northern locations and cities can increasingly complete with suburban and southern locations on merits.
So all is surely not lost in commercial real estate. While we may not make up all of the recession's losses in 2011, burgeoning trends will help on the way. Aggressively managing a portfolio along these lines could lock in cost savings for years to come when the market starts its inevitable climb.
Commercial Real Estate 2011: Opportunity Returns
With corporations earning record profits and lease deals still available, opportunity and growth will return to the commercial real estate sector in 2011.
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