Archives for December 2021

Plenty more goes into a deal in commercial real estate than an offer, a counteroffer, and an agreement to meet somewhere in the middle.

He hit me with a zinger! I certainly didn’t see it coming when I was showing a building and the prospective buyer asked after a long pause, “Well, what would you pay for the building if you were the one buying it?” Thus far, the tour had been a run-of-the-mill showing. I pointed out all the amazing attributes of the building, and the investor asked me leading questions alluding to potential deficiencies. It was the same rhythmic dance we always do, filled with questions of unbelieving doubt from the buyer and answers of remarkable certainty from the broker. Neither dare make mention of the word — negotiation — even though that is exactly what was happening.

In commercial real estate, we often view the concept of a negotiation as a high-low game, analogous to the proverbial used-car salesman — and we, as highly accomplished professionals, are much too sophisticated for that. Although if we are honest, the high-low game is the script for nearly every deal in commercial real estate, even if we refuse to admit it. But this approach is an easy pitfall, and there are more productive methods, especially in today’s data-driven commercial real estate industry.

When it comes to negotiation, there is a spectrum that exists. On one end lie people who are flippant, unaware, or nervous. The other side is made up of people who are measured, savvy, and confident. As usual, most CRE professionals fall somewhere in between. Let’s equip ourselves with additional tools to achieve more directed and successful outcomes in our CRE deal negotiations.

Tool #1: Identify Your Most Important Deal Points

In “The 7 Habits of Highly Effective People,” author Stephen Covey suggests we “begin with the end in mind.” Whether you are a buyer or seller, landlord or tenant, or lender or borrower, identify where you want to be at the finish line of the negotiation. It is even better to take it a step further by writing it down. For example, if you are a seller, prioritize your deal points. What deal terms are most important to you? And, of equal importance, what deal terms are less consequential? Then, identify where you would like to be in each of your areas of priority and write it down. The act of documenting it not only prevents drifting during the process, it also serves to unify the team, because a single person is rarely involved on each side of a deal. Once the goals are set, then develop a road map to get there.

My team represented a seller of a vacant office building. In the process, our client identified that price was important — when is it not? — but of greater significance was timing. The deal needed to close by the end of the calendar year. On the other hand, the amount of refundable earnest money and other typical deal points were of lesser concern. Armed with that information, my team was equipped to structure the deal in such a way that we agreed with the buyer on some key deal points to ensure the preferred date of closing.

Tool #2: Seek to Understand the Other Side’s Most Important Deal Points

“Be sympathetic with the other person’s ideas and desires.” That bit of wisdom comes alongside many others in Dale Carnegie’s book, “How to Win Friends & Influence People,” one of the greatest works ever written on negotiation. The truth is that human beings — that includes CRE professionals, believe it or not — are naturally self-centered. We are born selfish and oftentimes, even worse, groomed to be selfish. The challenge is that the negotiation table has two sides (and sometimes more). We cannot get to where we are going without helping the other side get to where they need to be. So, how do we understand where our counterpart needs to be? This isn’t a trick question — just ask. In the same way that we identify our priority deal points, encourage the other party to explain the deal points of significance for them. Once they have weighed in, we can find ways to work within the framework of achieving the other side’s goals, addressing their concerns, and finding solutions for their problems. Doing this will clarify the value of bargaining chips. In other words, what meaningless deal point can you give up — of which the same deal point is of value to your counterpart — to obtain a concession of value?

Weighted average lease term (WALT), for example, could be critically important for an investor deploying capital into a multitenant office building. A lengthy WALT will positively impact property value for an investor intending to sell. This dynamic played out in a recent deal where we represented a landlord in negotiating a lease with a new tenant – one who was comparing the economics of this lease with options at other nearby office buildings.

A key metric for the tenant was total out-of-pocket dollars spent throughout the life of the lease, assuming the same rental period across the board for all buildings. However, the landlord’s intention was to sell this asset, and we were already preparing to market the asset for sale. A lengthy WALT and a strong rental rate were important to the landlord because both heavily affected the building valuation. To meet the landlord’s two primary objectives, the tenant agreed to a higher rental rate and an additional three years of lease term than originally proposed, but we structured the deal in a way that included reduced annual rental increases, a base-year reset midway through the lease, and additional free rent on the front end that could be paid down in cash by the landlord. For the tenant, the economics of the deal achieved their goals when total out-of-pocket dollars were spread over the life of the deal. For the landlord, the WALT more than doubled, the Year 1 net operating income was maximized, and the building sold for a value that surpassed expectations. Voilà!

Tool #3: Gather and Leverage the Data

In his book “Moneyball,” Michael Lewis quotes John Henry, renowned investment manager and owner of the Boston Red Sox, in reference to a comparison between professional baseball and the financial markets: “People in both fields operate with beliefs and biases. To the extent you can eliminate both and replace them with data, you gain a clear advantage.” Since that book was published, data analytics has become a vital part of how almost every major professional sports team makes decisions. Data is equally important in commercial real estate negotiations. Most CRE professionals realize the importance of obtaining data, but few understand how to fully use it to achieve a successful outcome.

In a negotiation where we represented a buyer of a residential-style office building in a park with dozens of similar-sized office buildings, my team cherry-picked the comparable sales in the above chart and sent them to the seller’s representative, making a case for a purchase price around $90 per square foot. The full data points have been simplified for explanation.

The seller’s representative made the case that the purchase price should be closer to $100 per square foot — submitting the comparable sales above as justification.

At this point, our team was certainly tempted to accept the invitation from the seller’s broker to play the high-low game. Instead, we evaluated the seller’s comp set to determine how we could either work toward bridging the gap or defend our original position — all while trying to achieve our client’s goals. As we dissected both data sets, we were able to see that many of the seller’s comparable sales had already been renovated, while the property being bought still needed cosmetic renovation. That was telling from a qualitative analysis, but the most convincing case came when we put both sets of sales comps on a line graph to show the trend in sale price per square foot over time.

The line graph (above) was very helpful for both the buyer and the seller to understand the current value of the property as the next data point in a trendline. Ultimately, they agreed on a purchase price that equated to $87 per square foot. Both sides had data, but it wasn’t until it was dissected and brought to life that anyone truly understood how it brought relevance to the negotiation.

Negotiation: Art or Science?

That question is often debated, but most agree the ability to negotiate is critical — both in business and everyday life. According to multiple surveys, more than half of people in business aren’t confident or comfortable in negotiations. Adding these practical tools to your belt will undoubtedly give you more confidence at the negotiation table and will result in successful outcomes for you and your clients. And repetition at the negotiating table will also bring confidence, which will lead to success. So, to that end, go negotiate.

Source: “3 Tools for Negotiations“

“If liquidity in the market remains high, these coming maturities should not pose a problem.”

Outstanding CRE debt hit a new record in the third quarter at $5 trillion, fueled by liquid capital markets and pricing strength throughout commercial real estate asset classes.

New analysis from Trepp’s Matt Anderson notes that while some lenders paused lending in 2020, others—mostly GSEs, life companies and REITs—filled the void.

“The unabated growth of the CRE debt market has resulted in an increasing volume of CRE loans maturing in the next several years,” Anderson says. Annual maturities will reach an estimated $452 billion in 2022, a new annual record.”

Trepp estimates that $2.3 trillion of commercial real estate debt will mature over the next five years. In previous downturns, experts observed net contraction in outstanding loan amounts as CRE lending declined via a decrease in new loan originations and removal of existing loans through default and foreclosure.

But “the pandemic and its volatile economic impacts have barely had an impact on the aggregate CRE debt landscape,” Anderson says. “Low-interest rates and massive government-led stimulus have certainly helped. So have stronger-than-expected property price trends and lower-than-feared impacts on defaults and foreclosures. The deepest real estate impacts were seen in the lodging and regional mall sectors. But as travel and shopping have recovered—at least somewhat—even these sectors have experienced improved fundamentals in 2021.”

This sustained growth in the debt markets will lead to increasing volumes of maturing debt to the tune of $450 billion in 2022 alone, a new annual record. Trepp predicts that annual maturing volumes will remain above $400 billion throughout the next five years, according to Anderson.

“If liquidity in the market remains high, these coming maturities should not pose a problem,” he says. “Trepp estimates that total CRE origination volume was approximately $640 billion in 2020, an amount that would be more than sufficient to cover future maturities. But if liquidity becomes impaired—either through an interest rate or other market shock—there could be a shortfall in the amount of capital available to refinance the volume of maturing debt.”

Source: “Outstanding CRE Debt Hits New Record in Q3“

Apartments and industrial are the favorite asset classes for investors, driving much of the transaction activity.

There is a lot to celebrate this year. After a stagnant 2020, investor activity has rapidly rebounded this year to record-breaking levels. In the third quarter, transaction volume hit a new record of $205 billion, but it wasn’t a fluke. Tallying up the first three quarter of the year, transaction volume has exceeded the previous high by a fair margin, Doug Prickett, senior managing director of research and investment analytics at Transwestern, shared during a virtual Talk on Economic Indicators and the Impact on CRE earlier this month.

Transaction volumes were last this high the first three months of the year in 2007, illustrating the recovery. While investors are back in the market, there has been a notable shift in asset preference. Multifamily and industrial are the favored asset classes, pushing out office, the historical favorite. “Historically, office has been the favorite asset class, looking back to 2001-2005. Now it is clearly apartments followed by industrial,” says Prickett. Apartment transaction volumes have increased 43% over the last two years, while industrial is up 15% from 2019 volumes. Office and retail are both in the red compared to 2019, down 14% and 1% respectively. This isn’t necessarily pandemic related, Office and retail have been trading in the same band since 2015.

Investors are still acting cautiously in the wake of the pandemic. This has largely manifested as a flight to quality. “Investors are shifting their attention to the highest quality assets. This is largely to mitigate risk,” Prickett explains.

While the transaction activity is good news, it is unclear if the momentum will carry into next year. “The economy is tethered to the pandemic, and it will be for the foreseeable future—at least well into sometime next year,” says Prickett. “The variants will govern this recovery and that is best represented by the Omicron, which derailed the markets for a few days and thus had a reaction throughout the entire economy. The biggest risk is any future variants and their severity.”

Source: “Year-to-Date Transaction Volume is the Highest on Record“

Other brokers, published reports, and market conditions are key sources in assessing property value.

Location, location, location. It’s the quintessential catch phrase of the industry. But location isn’t everything when it comes to assessing a property.  The most comprehensive assessments are based on a broker’s experience as well as their knowledge of leading trends in the market.

“With income property, a prime consideration is cap rates—they’re especially good for commodity real estate such as a stabilized (leased up to about 85%) warehouse,” says John Culbertson, SIOR, manager, Cardinal Real Estate Partners, LLC, in Charlotte, N.C. “It’s also good for other properties, like freestanding drugstores. A Walgreens with a 20-year lease in Charlotte will sell for a similar cap rate as would one in Nashville, so you have a lot of examples.”

Where it becomes difficult, he continues, is when the property is specialized real estate—i.e., a church, a coliseum, or land. “Then you look at replacement values, cap rates, and comparables,” he says.

Often, he adds, it is the owner who has the best idea of what a property is worth. “Certainly, it’s important to understand what their expectations are, and to work together to develop a consensus on what the market value might be,” says Culbertson.

“The real estate market in Germany is not as transparent as in countries like the U.S. or the U.K., but usually we research rents and prices by checking publicly available reports from brokers, local business development agencies, and experts we know,” says Tobias Schultheiß, SIOR, managing partner for Blackbird Real Estate GmbH. “Also, we compare the subject property with similar ones we’ve sold in the past.”

Next, he says, he does a site visit in order to get confirmation of the information that has been gathered. “In order to get an overview of the existing property documentation, we ask the owner for access to a (virtual) data room,” he adds. “Once all the information is checked, we run several calculations—depending on the type of property (development or income producing): (i) a German income approach including Monte Carlo simulation, (ii) an IRR calculation and (iii) an extensive ‘beer cap calculation’ to summarize the most relevant key figures on one piece of paper.”

While his company usually does its own research, Schultheiß says that from time to time it makes sense to ask local brokers—for example, when there are no reports available. In addition, he says, “When a potential client wants to sell its property by means of a ‘share’ deal, it can be helpful to ask a tax lawyer in order to come to an after-tax value.”

Because his background includes doing appraisals, Arlon Brown, SIOR, senior advisor, SVN | Parsons Commercial Group in Boston, says he turns to comps and income, as well as the reproduction cost “quite a bit now” because the Boston market looks at new product over reproduction costs. “I also look at financing, because in our market rates keep going down,” he adds.

Brown says he also always looks at appraisers. “I have a group I give information to and ask information from; they seem to have a pulse on what’s going on at any particular point in time,” says Brown. “But the most valuable group I talk to are other SIORs; they are on the front lines and really have their pulse on what’s happening at that moment in time.” A third group he consults is bankers. “Most people have to get a mortgage,” he offers, adding that he looks not only at rates but also at loan to value and terms.

Culbertson says, “The only time I’ll reach out for an outside appraisal is when it’s beneficial to have the concrete information provided by a very credible third party.” For example, he shares, he’s working with a large family that is selling a tract of land valued at around $5 million. “The opinions of family members vary widely—from between $8,000 to $30,000 per acre—so it’s beneficial to get an objective third party to value the property with concrete, highly credible information,” he explains. In general, however, he says he finds appraisals to be overly conservative, particularly when a “value play” could be involved.

FACTORS AND VARIABLES

Depending on the type of property involved, several different factors may come into consideration when determining value. Of course, there is one element that is common in all properties.

“To me, location is the key driver for value—depending on the use of the subject building,” says Schultheiß. “Historically, tenant quality and WALT (the sum of individual tenant rent [economic rent] divided by total rent multiplied by remaining lease term) are important value drivers, e.g., for core properties. When it comes to core+ or value add buildings, the upside potential and related costs are important factors. And some rather new impacts derive from ESG (Environmental, Social, and Governance) questions. In Germany we have a lively discussion about ‘stranded assets’—properties that do not match ESG criteria and thus will no longer be interesting for tenants, investors, banks—resulting in a massive decrease in value.”

“Beyond location, I’d say complexity,” adds Culbertson. “Property with more complexity will trade at below fair market value.” Complexity, he explains, may involve the age of the asset and deferred maintenance, so there’s a lot of management needed. “Perhaps it’s a problem with the credit of a tenant; maybe the lease rates are below market and there are short-term leases; or there are some kind of toxics on the property,” he offers.

The attitude of the seller is also important, he continues. “A seller may be willing to be very aggressive if you want to make the case why a property may be worth more, but a lot of sellers I work with want to keep a low profile and will get less money,” says Culbertson.

“There are certainly a lot of things in the hot industrial market,” notes Brown. “The Amazons and Wayfares and Walmarts look at stud height, cube space—32-36 feet high—and how many dock doors. Insurance companies want to see a larger apron—from the end of the dock to the end of the asphalt of at least 135 feet. Parking has become more of an issue—the old one-to-one just won’t cut it.” Another factor, he adds, is tractor storage, and whether there is storage for additional boxes. “What we find is that in new industrial buildings they want everything—and there are not that many sites to accommodate them,” he summarizes.

Looking more globally, Brown says that beyond location, how a property will be accessed and how often people will use it becomes an important factor. “With sophisticated programs today, you can figure right down to the mile,” he says. In the Boston market, he adds, other factors include how long it might take to get permitted, how restrictive the zoning is, and even whether the building has a masonry front. “The final big thing we’re starting to see is that some companies are starting to restrict hours of operation,” he notes. “That impacts the utilization of the property.”

WHEN ARE YOU ‘DONE’?

When does the evaluation process end? When you “arrive” at a value, are you content that you have the answer, or are there factors you check and double-check, or update until the last possible moment?

“I think that’s a great question,” says Brown. “In such a dynamic environment you have to be checking what cap rates are, what interest rates are, sales comps, and the newest wrinkle, what building costs are.” He cites a situation where the sprinkler system in a fairly new warehouse needed to be updated. “The sprinkler guy was having difficulty getting piping, and getting cost, and the estimate was only good for two days,” he shares.

“I’m a big checklist guy,” says Culbertson. “We have an STP Matrix™ I look at that considers the seller’s circumstances, the transaction type, and the property characteristics. The other tool we use is Cardinal Due Diligence 360™—a 221-point list we go through thoroughly to make sure we don’t overlook anything. I like the confidence I get from my checklist.”

“In the past, my value assessments usually were +/- 5% around the achieved purchase price,” says Schultheiß. “Nevertheless, we have had a seller’s market for more than 10 years now in Germany, with investors who are more desperate to deploy their capital. This leads to situations that prices achieved are not in line with my assessment, but 10% and more above. Until today, I and my team have not yet found a way to include this in a formal value assessment.”

GOING DIGITAL
With new technology being developed at lightning speed, are there programs available that make the assessment process easier for CRE professionals?

“Real Capital Analytics has been a really big help,” says Brown. “We constantly get pitched on all software, but you have to really analyze what you want to do, decide on one, and go with it, and not keep changing.”

He adds that to help evaluate sales property his company has developed its own proprietary software, “Which has also helped a lot.”

“I am not a friend of using artificial intelligence in valuations since every building is different,” Schultheiß asserts. “AI may help in identifying rents and prices, but at the end of the day a human being has to bring in his experience and his gut feeling. The only thing that can make the outcome of a valuation more accurate is the input—and this is where Germany can learn from other countries; we are not as transparent compared to the U.S. or U.K., where you can identify almost any relevant information about a specific property by publicly available sources.”

“Technology is a double-edged sword,” says Culbertson. “Everyone can get the information, but how you analyze it is the most important.”

Which brings us back to the invaluable contribution that human insight brings to the evaluation process. “Information is now a commodity; it used to be that the broker was the arbiter of all information, and that was the single biggest point of value,” says Culbertson. “Now that has gone away; information on the Internet is superior, easier, and cheaper.”

So, what value does the broker bring? “The ability to help make very competent decisions,” says Culbertson. “The nuance of being able to negotiate on their behalf and to be able to distill large amounts of information quickly—and in a powerful way.”

Source: “The Price Is Right“