Patrick Fox, CEO of Consensus Strategies, a company specializing in specializes in strategic advocacy and survey research services for leading corporate and institutional clients, joins America’s Commercial Real Estate Show to discuss zoning and development trends all around the country for 2022. Discussion topics include strategies for building consensus within communities, how holding virtual meetings can affect developments, and some funny anecdotes from previous zoning projects.
Negotiating: Unsolicited Offers Above Fair Market Value and the Appraisal Perception Loop
We regularly work with buyers to make unsolicited offers for commercial real estate, usually in situations where a property is not optimally utilized, if utilized at all, i.e. where the current use is not the property’s highest and best use. Owners of these properties frequently would sell for a premium price, and my buyers frequently will pay more than market value. That feels like a match.
But then…
Market value is notoriously tough to pin down on commercial properties. Consequently, in the absence of a genuine concept for market value an unsolicited offer to an owner instead becomes an appraisal. Thus, a property that is really worth $2 million on which an owner receives an offer for $2.3 million is worth, to an owner, $2.3 million. Most commercial owners have no real need to sell and owners of properties not on the market don’t typically want to sell. Given this, in the face of a new “appraisal” – in the form of the offer just received – they’ll internally register a lack of desire to sell at market value. Thus, in the process of making an offer, market value is established in the mind of an owner by the unsolicited offer received. Ugh.
This happens frequently. I have developed techniques over time to mitigate the effect, but overcoming it is nonetheless an ongoing challenge. Commercial property investors are a confident lot, so much so in their opinions that they’ve put their money where their mouth was by investing in a non-liquid asset. Thus, once they have opinions, even where developed so casually, it can be a challenge to get them to change them.
There are two counterpoints to the “why would I sell at market value” objection:
Highest and best use values may not exist in perpetuity. They can be challenged by developed property pricing, by a property being penned in by surrounding development, and by missed opportunities with premium specific purpose buyers.
When a property is considered for redevelopment, it generally is trading at land value. That is a good thing for a seller. Higher and better use values are like a jackpot for an owner of a property otherwise becoming less viable over time. Land values are volatile, however, as they essentially represent a call option on the difference between the cost of developing the land, with the value of the land (the option, if you will) a function of the spread between the market value of developed property and developed cost. When the market rolls over, this intrinsic value can drop precipitously, even go negative, at which point the land value is low as it is nothing more than an option on anticipated future intrinsic value (market value of developed property and developed cost). Also, a use today may be obsolete tomorrow; gas stations as electric cars become more prevalent would seem to be one we’ll be witnessing in the coming years.
As one of many examples, I presented an offer for an old multifamily property that was clearly nearly double what the property was worth as a multifamily property. This was for a developer interested in the land and how it would fit into its large development adjacent to that multifamily property. The development will happen, after which there will be no interest in the land by another, thus the property will just be worth its value as a multifamily property, about half what my buyer offered. This was an incalcitrant family, surely thinking my buyer and I were out to get his property on the cheap. I can imagine conversations amongst the family discussing about this offer and how well the investment in the property has performed, congratulating each other on the wisdom of not selling. The reality is that it will take a long time, perhaps decades, for the nominal value to inflate to the price offered, and the inflation adjusted value many not do so in that seller’s grandchildren’s lives. I see this happen all the time, though this was one of the more extreme ones.
Foregone Monetization
If you have a vacant piece of land with a market value of $5 million, you likely have a piece of land that could be monetized for around $250,000 a year. The reason your land has the value it does is because of this potential monetization. Additionally, in most cases, the highest and best use of the land has peaked, and is not going to get better. Thus, by keeping the land vacant, you are only forgoing the income that the property could be garnering, income you could be earning if you sold the property and purchased one already generating income.
This adds up over time.
The chart above consider $100 of income producing property at a 5% constant capitalization rate with 2% net operating income growth versus the same $100 in vacant land appreciating at 2%, in line with growth in its monetization potential (potential net operating income) growth, and with no net income.
Consider $5 million of income producing property at a 5% cap rate with 2% rent growth and assuming market value at a future date also at a 5% cap rate. Alternatively, consider $5 million of vacant land appreciating at 2% with no net income. The investor with vacant land will have more value later, and will likely be very proud of his fine investment, but look at what has been forgone over time.
This isn’t the whole story. Sometimes there is the potential for a rapid change in the potential use of a property, particularly if a property is near a central business district. Also, vacant land doesn’t have zero income, it usually has either a net carrying cost, principally property taxes, or a small net operating income from pylon signage or other partial monetization. Also, in this chart above, I’ve not taken into account earnings from reinvestment of net operating income, which would make vacant land look even less appealing to hold on a relative basis.
For properties near the central business district, highest and best use can improve fairly dramatically. Years back, I recall numbers of two story multifamily properties surrounding a popular happy hour spot I frequented, The Firehouse. Today, most of those properties have been scraped to make way for high rise developments, and those that haven’t surely will be. That area changed rapidly. I see that as the exception, however, as most properties are nowhere near downtown.
Then There’s Thanksgiving Dinner
When one has owned something for a long time, there is a built in gain that brings with it genius cred. When the line at Thanksgiving Dinner is “you really called it with that purchase,” it becomes one’s identity. Sell it, and that will fade away, just blend into a balance sheet somewhere. Though it is a smarter move to sell, reinvest, and accumulate income, it is nowhere near as sexy as “X times what you paid for it.” In my dealings, I’ve come to believe that this is a factor, at least subconsciously, in the decision making process of many owners.
God Forbid Don’t Let Me Be the Sucker!
Finally, there is the strong motivation not to be the sucker that sold for less than what something became worth later. The easy way to avoid that is to always agree to sell for well over market value. That is, unless someone wants to pay that elevated price. If that happens, then as mentioned above, market value is perceived as equal to that offer, and the asking price can again be elevated. Problem solved.
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Video: LARC Analytics President and Co-Founder Ryan Meliker Presents Hotel Property Forecast 2022
Ryan Meliker, President and Co-Founder of Lodging Analytics Research & Consulting aka LARC Analytics, joins Michael, the show host, to discuss the hotel sector’s recovery from COVID, including drive-to and convention performance, major markets, and cap rate trends.
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Video: Jesse Shannon of Branch Properties Discusses Grocery-Anchored Retail Sector Outlook and 2022 Predictions
Jesse Shannon with Branch Properties joins Americas Commercial Real Estate Show to discuss grocery-anchored retail property performance in 2022.
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Video: Intelligent Building Co-Founder Tom Schircliff on Hybrid Working vs Intellectual & Cyber Security
In this video Tom Schircliff, co-founder of Intelligent Buildings, joins America’s Commercial Real Estate Show to discuss the challenges and solutions for property owners and business leaders as it relates to office workers becoming partly or fully remote. Today we want our people to be able to work from home, office or anywhere. We want to have smart, safe, well buildings bringing people together. We definitely need building and information cyber security as we must protect company information and intellectual property. Let’s also add our desire for effective productivity, recruiting, on-boarding, collaboration, training, and retention. Where do we turn?
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Video: Moody’s Analytics Senior Economist Thomas LaSalvia Provides Retail Insight 2022
Surprising intel on the retail industry is provided by Moody’s Analytics Senior Economist Thomas LaSalvia. Discussions herein include retail sales and trends for rental rates, occupancy rates, and cap rates for retail properties.
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Video: Real Page’s Carl Whitaker; Multifamily Keeps Rolling?
Carl Whitaker, Senior Manager – Market Analytics with Real Page, joins America’s Commercial Real Estate Show to discuss the current state and future of the multifamily sector. Carl starts by noting that rent growth is near 20% year over year nationally. He moves on to note that occupancy is running 97% and even increased from December to January, the first time ever his company has recorded an increase for those months.
In 2021, 674,000 apartment units were absorbed, beating a prior record of absorption by a whopping 60%. Even challenged markets, he noted are experiencing double digit rent growth. His company has been surprised at how quick the central business district markets have come back.
Real Page is still forecasting strong rent growth but not like 21. Affordability is a hot topic at Real Page, but Carl thinks this concern may be overstated, noting that rent to income over past year is 23%, not too far out of line with what REITs are reporting. This is less than I think most would think.
This is an excellent and highly informative video for anyone interested in multifamily property investing.
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Chart: The Stunning Pandemic Driven Plunge in the Labor Participation Rate
With news of Starbucks unionizing and personal experiences we have all had with unavailability of workers, this chart should come as no surprise. Nonetheless, it is a stunning thing to see it visually in a chart like the one above. The peak just before the plunge was 63.5%. Two months later, it bottomed out at 60.2%. That is a difference of 3.3%, and a difference of 5.2% of the pre-decline number (3.3% decline / 63.5% before the decline). Labor has thus been in control, at least for the moment.
This is contributing to increasing inflation expectations as can be seen in the TIPS spread. Though still down, the labor force participation rate is rising from its mid-pandemic lowers, however. Thus this plainly evident stress point of worker shortages may improve in coming months.
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Chart: Inflation Watch 2021 Intra-Quarter Update; Inflation Expectations Climbing
The 5-year TIPS spread, after almost calmly sitting a bit elevated over pre-pandemic levels in late 2021, has now spiked of a sudden spiked to the highest level in a number of years and to a level about 70% higher than where it was generally hovering pre-pandemic. There has been much talk in the financial press of inflation pressures in recent weeks, and the war in Ukraine looks like it will only exacerbate this.
“There are two main drivers of asset class returns – inflation and growth.”
~Ray Dalio
Real Money at Stake
Real money is at stake with these spreads. TIPS pay interest every six months, based on a fixed rate that is calculated by multiplying the adjusted principal by one-half the calculated interest rate (i.e. half a year’s worth of inflation at that rate). Thus, a “bet” that an investor makes in with these bonds has real financial implications. If actual inflation is higher than priced in the markets, a TIPS buyer will make more that a straight treasury buyer. If it is lower, that TIPS buyer will make less. How much money is at stake? In 2017 Morningstar pegged the market at $1.2 trillion. Thus, every 1/10% difference (10 bp) is a $1.2 billion swing. That is real money by my count.
Generally on Inflation and Commercial Real Estate
What is the impact of inflation on commercial real estate? In the near term, higher inflation tends to bring higher interest rates. Higher interest rates are a negative for commercial real estate in the near term. Higher rates means larger debt service payments, reducing the buying power of purchasers and negatively impacting deal economics. It also means makes fixed income investments a more competitive investment, likely pulling capitalization rates (cap rates) up, thus pricing down. Over a longer period, however, the prospect of inflation leads to a principal benefit of commercial property investment, that of its potential as a hedge against inflation. After all, more inflation should lead to higher rent, at least in time.
MIT published an excellent whitepaper on real estate’s ability to keep pace with inflation with data to 2016. They looked at then tendency of retail, multifamily, industrial, and office income and values to keep pace with inflation. The best at keeping pace income-wise was retail, with rent growth of 102% of inflation. Office was the worst performing at a quite dismal 18%. Values across the property types were more consistently kept pace, with retail again doing the best appreciating at 107% of inflation, office again the worst at 74% of inflation. I’ll speculate that the fairly drastic difference between income and value keeping pace with inflation is driven by vacancy. If you’re interested in the topic, read the paper.
Expectations for inflation also come into play with lease structure and due diligence. A lease structure with a fixed rent increase becomes less attractive for a landlord with higher inflation expectations. Similarly, a commercial property being acquired with existing leasing in place that have fixed or capped rent increases looks less attractive as inflation expectations increase. Also, a property being purchased with fixed rate financing will look increasingly attractive if a buyer anticipates inflation fueled increases in income. Inflation, in short, is very important to commercial property investors.
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Video: MSCI & Real Capital Analytics Chief Economist Provide Office Sector Update
Jim Costello, Chief Economist with MSCI and Real Capital Analytics, shares his views on the office property market, including cap rates, impact of COVID-19, hybrid work, and rising interest rates.
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