Are you buying time until the market recovers? If so, do you know if it is worth the investment?

We are approaching the three year mark since the start of the Great Recession. The Feds have stimulated the economy and worked their best monetary policy but it feels like we are having our own Lost Decade a la Japan of the ‘90s.

ü Employment growth has been tepid at best. With the Census jobs ending and state and municipal government’s cutting upwards of 500,000 jobs and private companies in no hurry to add payroll, the recovery in jobs – the leading demand driver for real estate – is going to take a long time (Economists forecast that it will be 2014 or later before American payrolls recover to their pre-recession levels).
ü Vacancies are climbing and rental rates are declining as absorption in most commercial markets continues to be negative with reversal of these trends tied to real employment growth and proven economic recovery.
ü Financial reform and other external forces are making the process of refinancing commercial mortgage loans a long and arduous task with only the highest quality properties getting financed – a situation which will not be alleviated any time soon.

For owners of income-producing properties which have suffered, or anticipate suffering, the loss of tenants and/or the realities of lease rate reductions covering regular debt service has become a challenge with many having to fund payments from other sources.

Further, as tenants’ leases roll, financially-strapped owners do not have the funds to pay for tenant improvements or leasing commissions – thereby taking the property out of the market and putting a cap on occupancy. The volume of these buildings has grown to where they have a name – Zombie Buildings – since they are the living dead.

As an owner, if you find yourself feeding a property one way or another, you are buying time until the market recovers. The question becomes: Is it worth the investment?

Recently, I had a client approach me for advice on an 80,000 sq. ft. building which went from 100% occupancy to zero as a result of one tenant not renewing its lease at expiration and another going bankrupt. Facing an uphill battle to lease the property, my client asked the right question: Does it make economic sense to carry the building and lease it up?

The Background: My client had a $12.5 million first mortgage secured by the building which had annual debt service approximating $850,000. Real Estate taxes are $236,000 annually while insurance, utilities and maintenance ran $6.00 per square foot. As a result, holding costs are running around $130,000 per month.

To answer my client’s question I obtained the facts on the property including operating expense estimates, primary loan terms, recent leasing proposals and current marketing materials. I also gathered published third-party market information from several brokerage firms.

From the materials gathered, I gained an understanding of market rents, occupancies, absorption, lease terms, tenant improvement allowances and the contractual lease commission rates.

Using this information, I prepared two financial analyses: a Break-even Rent Analysis and a Solvency Test.

1. In the Break Even Rent Analysis, I calculated the gross rent per square foot which the building would need to achieve in order to cover operating expenses and debt service and to recover the leasing costs over an average lease term under two scenarios: One at market occupancy and one at full occupancy.
2. In the Solvency Test, I calculated a pro forma net operating income at the Property’s asking rents, budgeted operating expenses and estimated the value upon lease-up utilizing “normalized” cap rates and deducted an estimate for selling and closing costs, the mortgage balance as well as the leasing costs to determine net residual value to equity – or the Project’s Solvency.

Accordingly, in my Breakeven Rent Analysis, I determined that the break even rent would be 30% above the Property’s current asking rents at market occupancy and 6% above average asking rents at full occupancy – and both were above current sub-market asking rents. My conclusion was that the property could not achieve break-even rent in the market – currently or in the foreseeable future. In my Solvency Test, I determined that if the property only leased up to market occupancy, it was insolvent (the owner’s would lose money from the sale of the property) and that it would recover a net of $800,000 if the property were leased to full occupancy which, at the $130,000 per month burn rate, would cover roughly six months of holding costs – clearly not a feasible timeframe during which the building could be leased and occupied.

Given the current market conditions, I determined that the best option for our client was to negotiate a deed in lieu or short sale with the lender.

Real estate investors believe in their properties – that is a significant factor in buying one property over another. That belief, when combined with an optimistic perspective, can lead an owner to continue feeding a property with the hope of recovering their capital and making a return. Many times, like in the example presented above, buying time is a bad investment.

Starting with these quick analyses, owners can start making some decisions which will lead to either the development of a business plan which is used to renegotiate certain of the mortgage terms or make arrangements to give the lender the keys. Of course, extraneous facts and circumstances, like loan guarantees, additional collateral and leasing reserves, can make the decision and the action plan more difficult to effect.

As a CPA, a CRE and a FRICS with over 30 years of experience in underwriting, analyzing and valuing real properties to help clients buy, sell, finance or workout their debt, I can help you to see the risk within the numbers and to effect the most appropriate strategy. For a free one-hour consultation, phone me at 305-665-2450.