Commercial Real Estate Property Analysis & Market Analysis
Real property refers to land, buildings, fixtures, and all other improvements to land. The terms "land," "real estate," and "real property" tend to be used interchangeably. Commercial real estate is any real property that is not inhabited for the purpose of a primary residence only. In addition, commercial real estate is an asset class of itself and is an acceptable, alternative investment to equity and debt securities and part of an asset allocation / diversification plan.
- Commercial real estate is purchased as an investment for income generation, tax specific investment, owner-occupancy utilization and value appreciation investment. The key considerations that investors look for when analyzing a property (regardless of being on either the equity or debt side) include:
- Positive cash flow or at least a break-even cash flow to cover the operating expenses of owning the property.
- Appreciation of market value of the property in the event that cash flow is minimal.
- Amortization of the mortgage by the property's cash flow in a reasonable amount of time so that equity builds up. The payments from the tenants essentially services the mortgage and pays for the property.
- Tax laws / regulations (existing and pending revisions) that allow taxable income to be reduced by tax deductible expenses related to the operation of the property, mortgage interest expense, and depreciation / cost-recovery (non-cash deduction) related to the presumed decline in value of the property over time due to usage and wear (when in reality the property is actually apprciating in value over time due to inflation). The capital gain received upon the sale of the property at a future date has its own specific tax treatment.
- Availability of credit from financial institutions. The acquisition of a property can be leveraged, which means that the purchaser puts down a certain percentage of capital as a down payment (equity) and the balance of the purchase price is financed. In order to do this, banks have to be willing and able to lend.
- In addition, when compared to other investments, owning real property provides one with the opportunity that insurance can be purchased to protect the asset in the event of damage, and the cash flow from the property can be used to pay the premium for that insurance policy coverage.
- The trade-off is that real estate is not a very liquid asset. In order to take cash out of the property it either must be sold or refinanced. In order to sell the property, an interested and capable purchaser must be located and there is a certain amount of time required for the transaction to be completed. In order to refinance the property, there must be sufficient equity in the property and there must be available credit from a financial institution.
- Regulatory guidelines on land usage regarding agricultural, residential or commercial development. These guidelines are ssen as either preservationist or as a barrier to growth.
- Regulatory guidelines on building height and building density constrains supply. When heights and density regulations are relaxed, it requires less land to satisfy demand.
- Higher real estate taxes on vacant land is an incentive to develop the land. Lower tax rates on improved property is an incentive to purchase and own the property.
- The inflation-adjusted cost of building construction in relation to the inflation-adjusted cost of property purchase. Shiller indicates that overall, the cost to build residential housing has been stable while the actual cost to a purchaser has increased 30% since the 1980s.
- Economic cycle. A property cannot be purchased if there are insufficient tenants to lease it to, or insufficient business for it to be owner-occupied, or insufficient jobs for individuals to provide sufficient income to purchase and maintain a residential property. A property cannot be sold if a potential purchaser has insecurity in relation future economic prospects, and/or cannot obtaining financing from a financial institution with the same insecure outlook.
- National, regional, or local population growth (family formation). The South is the fastest growing region of the United States.
- Urban areas have become the location for the development of new, knowledge-based industry job categories.
- Price controls in the form of rent control or rent stabilization guidelines can result in a barrier to further development (renovation or construction), and/or lead to a black market or a patchwork approach to exemptions.
- Commercial real estate properties are:
- Retail properties (stand-alone, regional shopping malls, big box retailer center, outlet centers, lifestyle center, mixed-use center, grocery anchored neighborhood center, unanchored neighborhood strip shopping centers, power centers, specialty retail)
- Office buildings (A, B and C quality based on design, location and tenant level; central business district (CBD), suburban, medical office, single tenant, corporate facilities; New York City (Manhattan) is considered the largest office market in the United States with approximately 390.7 million square feet)
- Hotels and resorts (chain / branded and individual, full service luxury and mid-market, limited service / budget, boutique, extended stay)
- Multi-unit / multi-family residential low-rise and high-rise (rental apartments, condominiums, leaseholds and cooperatives, student housing, affordable housing)
- Warehouses / Distribution Facilities (used by manufacturers, retailers, transportation companies, third-party logistics providers)
- Industrial (heavy and light manufacturing, research, flex, cold storage, telecommunications)
- Health care Facilities and Hospitals
- Mixed-use properties (urban residential and office / retail, planned residential communities, lifestyle centers, public / private ventures, industrial / office parks)
- Raw or partially developed land, agricultural property and forest tract (and in the few states where they are considered real property, oil and other types of mineral rights)
- Construction project
- All categories are further sub-divided by urban, suburban, exurban or rural location./dt>
- Alternative commercial real estate properties are:
- Student Housing
- Data Centers
- Gasoline stations
- Convenience stores (franchise and non-franchise)
- Medical office buildings
- Seniors housing
- Agricultural land
- In the United States, primary real estate markets tend to follow U.S. government Metropolitan Statistical Area (MSA) designations. MSAs are delineated on the basis of metro area population size within a continguous area, not by income. The largest MSAs (2013 Census Data):
- 1. New York–Northern New Jersey–Long Island
- 2. Los Angeles–Long Beach–Santa Ana
- 3. Chicago–Naperville–Joliet
- 4. Dallas–Fort Worth–Arlington
- 5. Houston–Sugar Land–Baytown
- 6. Philadelphia–Camden–Wilmington
- 7. Washington–Arlington–Alexandria
- 8. Miami–Fort Lauderdale–Pompano Beach
- 9. Atlanta–Sandy Springs–Marietta
- 10. Boston–Cambridge–Quincy
- 11. San Francisco–Oakland–Fremont
- 12. Phoenix–Mesa–Scottsdale
- 13. Riverside–San Bernardino–Ontario
- 14. Detroit-Warren-Livonia
- 15. Seattle–Tacoma–Bellevue
- 16. Minneapolis–St. Paul–Bloomington
- 17. San Diego–Carlsbad–San Marcos
- 18. Tampa–St. Petersburg–Clearwater
- 19. St. Louis
- 20. Baltimore–Towson
- Owners of real estate include:
- Publicly traded REITs
- Private real estate funds
- Domestic and foreign financial institutions
- Life insurance companies
- Sovereign wealth funds
- Pension trusts
- Individual investors
- Loans secured by real estate can be divided into 3 categories based on the source of repayment:
- Construction loan / project financing where the land and structure(s) are developed to the point of sale or leasing and the loan is paid off or converted to a permanent mortgage.
- Acquisition / refinancing of real estate where the source of the repayment of the loan is the income generated by the real estate leases, fees, etc.
- Credit-based loans, which are secured by real estate but will be repaid from the borrower's business operations at the property or personal assets.
- Commercial real estate financing is further categorized by structure:
- Taxable construction, supplemental and permanent loans (generally secured by some combination of a lien on the real estate, an assignment of cash flows from the property or personal guarantees from the real estate developer).
- Tax exempt and taxable bonds and bond securitizations (tax exempt bonds are issued by state or local governments or their agencies or authorities that are issued primarily to finance multi-family housing projects. These bonds are secured by an assignment of the related mortgage loans and a general assignment of rents of the underlying multi-family housing projects. No government is liable under these tax-exempt bonds, and government taxing power is not pledged to the payment of principal or interest under these tax-exempt bonds).
- The primary risks of owning and / or lending against commercial real estate are:
- Fluctuations in the property's value due to the decline in demand for a particular type of real estate property, the over-building of similar real estate properties or in response to general / regional economic conditions.
- Higher expenses or lower income than projected due to changes in either national or regional demographic, general economic and business conditions.
- Inability to renew leases or relet space as leases expire or the renewal of leases at less favorable terms than current lease terms.
- Insolvency or bankruptcy of a major tenant that substantiall reduces the operating income of the property.
- Unavailablity or inability to secure long-term, favorable term or sufficient financing.
- Expiration of either long-term leasehold or operating sublease interests in the land and the improvements (rather than actual ownership of the of the property by a fee interest in the land).
- Changes and/or revision in tax laws or other regulatory systems that affect operations or result in a failure to comply with applicable tax laws.
- Structured finance investments such as mezzanine loans, junior participations and preferred equity interests may or may not be recourse obligations of the borrower in the event of a substantial decline in the value of the property.
- Environmental problems and liability may result in a requirement for additional capital.
- Acts of terrorism may adversely affect the value of properties and / or the ability of a property to generate sufficient cash flow, and could cause insurance premiums to increase significantly. The Terrorism Risk Insurance Program Reauthorization and Extension Act of 2007 (TRIPRA) has been extended by the U.S. Congress in December 2007 until December 31, 2014 (this is originally the Terrorism Risk Insurance Act / TRIA, which was enacted in November 2002). The law extends the federal Terrorism Insurance Program that requires insurance companies to offer terrorism coverage and provides for compensation for insured losses resulting from acts of terrorism.
- The ground lease may include certain covenants:
- Obligation to build: the lessee is requirde to construct a structure within a certain time frame.
- Right to mortgage: the property owner can encumber the land with a mortgage independent of the improvements on the property. Conversely, the lessee can encumber the leasehold improvements with a mortgage without the prior consent of the owner (landlord).
- Ground lease Credit issues:
- If the ground lease has a renenwal option(s) that are not clearly defined and the owner and lessor cannot come to terms then lease may terminate early or the new terms may not be viable for the lessor and any sub-tenants.
- It is possible that the tenant's business / financial affairs could result in a lien(s) to be placed on the property that could result in the landlord losing the fee interest and / or the improvements. Similarly, the Comprehensive Environmental Liability Response Act of 1980 (CERCLA) (42 U.S.C. § 9601 et seq.) indicates that the landlord and tenant are jointly and severally liable for contamination of the property when a hazardous substance or condition is present on the property during the term of a lease. www.law.cornell.edu/uscode/42/9601.html
- If the owner / lessor enters into a fee interest mortgage (mortgage on the underlying land) then the leasehold mortgagee must require the owner / landlord to subordinate the landlord’s fee interest in the property, and any fee mortgage, to the ground lease and the leasehold mortgage; or there must be a Subordination, Non-Disturbance and Attornment Agreement (SNDA), which clearly indicates that the possession of the leasehold improvements shall not be disturbed, affected, impaired by, nor the lease or the term terminated, a foreclosure and/or suit brought against the land owner in relation to a fee interest mortgage, or any judicial sale of the mortgaged property.
- If the lessee enters into a mortgage on the leasehold improvements then the mortgagee must have the right to take over the lease upon foreclosure.
The most basic ground lease involves the owner (Lessor) of an unimproved parcel of land leasing it to an unaffiliated second party (Lessee) for commercial purposes. The reason why a lessee may enter into this type of arrangement is that the location of the property may be very good but the owner just does not want to sell it. Similarly, the price of the land may be too high to purchase and the purchaser may not have sufficient funds afterwards to construct a viable commercial structure / develop the property. Conversely, the owner may enter into the arrangement because they retain the fee simple ownership of the property and will receive a steady income stream from a tenant who has made a substantial investment in the construction of a building(s) on the property, which the landlord may never would have had the funds to develop on his own. The tenant is bearing all of the risk and cost of the development project.
Any improvements (both above and below ground) constructed on or at the property revert to the landlord upon the termination of the ground lease. Thus, the lessee must accurately draft a cost benefit analysis that will clearly demonstrate that the annual lease payments and cost to construct any improvements will result in a commercial enterprise that provides an income stream that compensates for the expenses and provides a predetermined profit.
The lease term is usually long term, which is a relevant statement: for some 25 years may be sufficient while it is not uncommon for leases to be for 99 years (or even exceed 100 years; a shorter initial term may also have multiple renewal options but may include rent amount increases). The tenant constructs a commercial building(s) and other improvements whose economic life and functionality will coincide with the length of the lease. The tenant can construct a structure for owner-occupied purposes (a manufacturing facility, warehouse) or can construct structure to be leased to sub-tenants (retail stores).
Any lease between the lessee and their sub-tenants may not exceed the term of the ground lease.
The ground lease is normally on a non-recourse to the lessee basis: the obligation(s) of tenant under the terms of the lease is dependent upon the commercial operation conducted on the land and not the credit worthiness of the lessee.
- Construction lending carries substantial risk. Why is construction lending a poor prospect for a financial institution?
- In some ways construction lending is almost like a futures contract: the financial institution is lending today against an asset that will be delivered at a later date and will be sold / valued at a later date. The financial institution has little opportunity to hedge against this situation.
- In the past, borrowers had only to put up approximately 10% of the total cost of the project but could earn as much as a 25% to 50% return on their investment. Conversely, the financial institution that provides 90% or better of the amount of the construction project cost earns only a single digit interest return for taking on substantially all of the risk.
- Lenders also tend to create interest reserves (from the proceeds of the loan), which are used to make the monthly interest payment on the behalf of the borrower during the construction phase. However, what this really means is that the financial instituion is not earning anything on the loan. Rather, the principal is increasing by the amount of the monthly interest payment. The final principal balance is supposed to be repaid on the back end when the construction loan is taken out by a permanent mortgage. However, if the project is not completed then the outstanding amount of the principal may not be fully repaid.
- Some of the unique set of risks related to construction lending include:
- The entire amount of funding allocated by the lender to the project cannot be released all at once at the beginning of construction. Rather, funding must be released in increments as specific phases of the project construction are completed and new phases are commenced, and as various percentages of unit sales / leasing at the project are committed to by purchasers / tenants. This means that the lender must have, and rely upon, the expertise of either an in-house or impartial third party inspector who can verify that various phases of the construction have been completed in an appropriate manner (and authorize the release of the next amount of funding).
- If the lender releases funds for the land acquisition and initial start-up of construction but the borrower / project developer does not commence construction then the lender may have to foreclose on raw or only partially improved land that does not have sufficient value to cover the initial release of funding.
- If a certain amount of funding is released and the project developer becomes insolvent or there is some type of problem that halts the project then the lender may have to foreclose on a property that is incomplete, may not recover all or a partial amount of funding from the borrower, may have to hire a new company to come in and complete the project and provide additional funding to that new developer, and may only be able to sell units or lease space at a discount due to publicized or perceived problems connected to the property and project.
The financial institution, regardless of any statement made by the borrower, must make certain that the contractor has an active license in the municipal jurisdiction where the project is located. The financial institution should also independently verify references and investigate the contractor’s qualifications and experience. The contractor must be able to demonstrate that he/she has adequate insurance coverage, including comprehensive general liability and workers’ compensation, preferably from an A-rated carrier, and verify the contractor’s ability to obtain payment and performance bonds (see next).
The general contractor should be required to carry payment and/or performance bonds on the project. The premium for such bonding is usually paid by the owner (the borrower). A performance bond ensures that the construction of the project will be completed even if the contractor is unable to do. A payment bond ensures that the subcontractors and suppliers on the project will be paid if the general contractor fails to pay them.
Prior to construction and throughout the construction phase, the general contractor is required to provide a schedule of values or a budget for the project to help ensure that the contractor stays within the contract price and to guard against overpayment. Further, the contract should provide that the owner may withhold a retainage fee of 5.0% to 10.0% from each progress payment until the work is fully completed and inspected (and the time for subcontractors and suppliers to record mechanics’ liens has expired). The financial institution / owner should also receive timely audits, a full accounting for the project and documentation of expenses with each draw request.
A Building Permit must be issued by the building department of the proper municipal authority. The permit is the legal permission to commence construction of the building project in accordance with the approved drawing plans and specifications. The insurance company many not cover the work completed without the permit and periodic on-site inspections. The actual construction, which includes the design, materials, and the interconnection and application of materials must follow the local building code.
The designation of either vacant land or a location as a Special Economic Zone (SEZ) can increase the value of the property. The first key consideration is whether the infrastructure of water, sewage, gas, and electricity is already been brought to the site. Developers and/or tenants usually receive tax and regulatory / permit incentives to operate withing the SEZ. The tax incentives offered to potential investors, developers or tenants can result in short-term foregone tax revenue (both sales and real property) to the municipality or state.
National Association of Home Builders, Multifamily Market Survey (MMS) http://www.nahb.org/en/research/housing-economics/housing-indexes/multifamily-market-survey.aspx