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Jack Friedman
Commercial Real Estate in the Current Economic Climate

What lies ahead and what CPAs can do to help their clients.

April 6, 2009
by Jack Friedman, CPA, ABV

Falling housing prices and subprime mortgage problems have grabbed the headlines for almost two years. By contrast, commercial real estate and related mortgages have reportedly been holding up well. Why is that? Can that continue? How important is that segment of the economy? What can a CPA do to assist his or her clients?

Commercial real estate is primarily composed of four traditional property types: apartments, industrial, retail and office. Hotels and various specialty properties make up a smaller but important segment of the market.

Generalizations about commercial real estate will not be accurate for any specific property. For example, in a generally weak national retail market, there may be strong pockets or submarkets within certain cities. As you read this, CPA Insider™ readers should keep in mind that there is a wide variety of properties and a lack of uniformity across both geographic and economic boundaries.

Real-time Economic Slump vs. Commercial Real Estate Slump

There is a significant time lag between the initial signs of economic recession and a noticeable change in reported statistics for commercial real estate. Adjustments of supply and demand are noticeably slower for real estate than for other segments of the economy. Retail and office properties are generally more susceptible to economic fluctuation than apartments and industrial property. Hotel effects will vary depending on the type (vacation, convention, business traveler, roadside).

Because of their visibility, retail centers are the type principally described here. Most retail shopping centers are “anchored” by one or more major creditworthy tenants. These creditworthy tenants agree to lengthy leases (10 years to 50 years) and pay less rent per square-foot than the smaller national or local tenants. Anchors provide the financial stability of the center and attract patronage for the other tenants, who often cannot or do not advertise.

The smaller tenants’ leases are for shorter terms than anchors: three-, five- or 10 years. Base rental rates are often increased prospectively by percentage rent, the amount of which depends on tenants’ gross sales. Percentage rates may vary from one percent to nearly 10 percent of sales in excess of a stated base sales amount. The percentages are often established based on a retailer’s expected benefit from being in the center and vary by type of retailer. For example, a jewelry store will pay a much higher percentage than a hairstylist.

Types of Leases

Leases may be net, semi-net or gross, indicating whether the landlord or the tenant pays certain expenses or expenses over a base annual amount, called a “stop.”

From the boom years that ended in 2006 or so, economic conditions have deteriorated in many respects. However, because of long-term leases (most five years or longer) and long-term financing (interest-only for 10 or more years), with renewals staggered across properties and leases within properties, the worst of the problems facing shopping centers and other commercial real estate as a result of the current recession have not yet been experienced.

Many local and national non-anchor tenants have experienced sales declines of five percent to 30 percent in 2008 compared with 2007 and profits have evaporated. Retailers, including those selling appliances, electronics, apparel, home furnishings and books, have been closing stores to reduce costs. Financing for the entire shopping center is often based on the term and amount of the lease(s) of the anchor tenant(s). Initial permanent financing for a shopping center is typically at a 75 percent loan-to-value ratio, also limited by a 1.25 to 1.30 debt-coverage ratio. This means that net operating income (rental income minus operating expenses) exceeds annual debt requirements by 25 percent to 30 percent).

Theoretically, a shopping center so financed can endure a vacancy rate of 20 percent and still break even on cash flow. However, many shopping centers are overleveraged and cannot endure a vacancy rate much greater than 10 percent. Vacancies beyond 10 percent could send many centers into foreclosure. Loss of one anchor tenant or a few smaller tenants upon lease expiration or bankruptcy can wreak havoc on shopping center owners. A sample of retail tenants in jeopardy of bankruptcy can be found easily. Many publicly-owned companies have stocks selling for less than five dollars per share, while some for under-two dollars and others are in bankruptcy.

Financial Effects of Tenant Loss

When a tenant closes, three negative financial effects can affect the financial situation of a shopping center. First is the loss of base rent, second the loss of percentage rent and third the loss of expense reimbursement and contributions to common area maintenance. Loss of a tenant can reduce the center’s power to draw customers to other tenants, possibly triggering a death spiral. Replacement tenants are often scavengers seeking the lowest rent, such as karate schools or bingo parlors, not customer draws.

Consolidation such as is being experienced in the banking industry will cause increased vacancies. Wells Fargo/Wachovia, Bank of America/Countrywide and JPMorgan Chase/Washington Mutual are examples of consolidation where you can expect facilities near each other to close as soon as is practical.

In addition, when 10-year “bullet” loans, having no amortization payments, come due, the shopping center owner must scramble to refinance. Life insurance companies, pension funds, banks and other institutional lenders may not be in a position to roll over the same principal amount. They have been looking forward to receipt of cash at maturity. Many commercial-property loans have been sliced and diced into mortgage-backed securities, making them virtually impossible to renegotiate.

Institutions that are willing to lend will demand new appraisals. Appraisers will take into account reduced rental rates, higher vacancies, lower loan-to-value ratios and higher capitalization rates (reducing values). Shopping centers that cannot be refinanced or that require substantial cash infusions that owners cannot meet, are likely to be foreclosed.

So, as retailers’ problems become apparent and their stores begin to go dark, recession reality will set in. Although the retail property market is a very small part of the general economy, it is highly visible and any problems will exacerbate those of greatly beleaguered financial institutions. The result will be much the same with office buildings, although they are less visible than retail properties. The same will spread to industrial properties and apartments, to a lesser extent in most areas.

How CPAs Can Help

CPAs may be better able to assist their clients by learning more about rental real estate. CPAs can provide pro formas with “what if” scenarios to assist owners to decide on offering rent reductions, lease renewal terms and refinancing assistance. CPAs can also apply their skills to understanding real estate finance, appraisal, investment, rental market competition and property marketing issues.

You can help their clients avert the loss of property through forward-looking financial methodologies, instead of focusing on historical performance.

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Jack P. Friedman, CPA, ABV, CFF, is a real estate author, appraiser and economist in Dallas, Texas. He is a state-certified appraiser, with ASA, MAI and CRE designations. You can reach him by visiting www.realexperts.com.