Commercial Real Estate

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Commercial real estate is property used solely for business purposes. Office buildings, malls, industrial parks, hotels, convenience stores, apartment complexes and gas stations are all examples of commercial real estate.

Commercial real estate is distinct from residential real estate, which has been under the microscope in 2007 and 2008 due to the subprime lending crisis. Issues related to the failure of mortgage-backed securities have driven property values down and created problems for both home owners and institutional lenders, and this has had a rippling effect on other parts of the economy. The commercial real estate market has suffered from the fall-out, but it has not bled as deeply as its residential cousin.

Contractors who Build Commercial Properties

These companies depend on the relative strength of the commercial real estate market to earn new contracts, as well as the continued financing of their current projects by existing developers.

  • Fluor Corporation is the largest firm in this market, and offers engineering, procurement, construction management, and project management services worldwide.
  • McDermott International is an engineering and construction company worldwide. The company operates in three segments: Offshore Oil and Gas Construction, Government Operations, and Power Generation Systems.
  • Foster Wheeler provides construction and engineering services to the oil and gas industry, as well as chemical, pharmaceutical, and power plant operation sectors.
  • Perini offers general contracting, construction management, and design-build services to private and public clients.
  • Granite Construction is a heavy civil contractor, building public works and producing construction materials for public and private sector clients in the United States.

REITs

Real estate investment trusts, or REITS, are corporations or trusts that pool the capital of many investors to purchase income property (equity REIT) and/or mortgage loans (mortgage REIT). An equity REIT owns and manages property, as opposed to a mortgage REIT which purchases mortgages and may also borrow money from banks to lend again at higher interest rates. REITs that invest in commercial real estate can do so through commercial loans, or through the development and ownership of property. Shares in a REIT are publicly traded on stock exchanges, and these companies are eligible for corporate income tax exemptions but in return are required to distribute 90% of their income to shareholders as dividends.

REITs are exposed to the volatility of the commercial real estate market in that their revenues will decline if rents and property values are low, or if costs of development or borrowed capital are too high. However, most REITs have diverse portfolios with holdings in a variety of economic sectors and geographic regions, helping them to shield them from isolated fluctuations in the market. Below is a list of commercial REITs, broken down by the sector on which they focus.

Office REITs

These REITs focus on the development and/or ownership of office buildings.[1]

Hotel/Motel REITs

These REITs focus on the development and/or ownership of hotel properties.

Industrial REITs

These REITs focus on the development and/or ownership of industrial complexes.

Retail REITs

These REITs focus on the development and/or ownership of properties that serve the retail sector.

Other Companies that Develop Commercial Properties

These companies develop commercial properties and sell them to investors. They depend on the health of the market to maintain properties above development costs, so that their business is profitable. Most commercial real estate development is financed by large Real Estate Investment Trusts (REITs, see below How To Invest in Commercial Real Estate), so firms in this category are smaller in scale.

  • St. Joe Company has four segments: Residential Real Estate, Commercial Real Estate, Rural Land Sales, and Forestry, and it builds properties for retail, multi-family, office, and industrial uses.
  • AMREP (AXR) sells developed and undeveloped lots to national, regional, and local homebuilders, and commercial and industrial property developers in Rio Rancho, New Mexico.
  • Trammel Crow Company, a wholly owned subsidiary of CB Richard Ellis Group (CBG) offers a full range of commercial real estate development services. The services range from site identification, due diligence and acquisition to project finance advisory services to construction bidding and management to project close-out and tenant move coordination.

How To Invest in Commercial Real Estate

There are two basic ways to invest in commercial real estate:[2]

Direct Investment in Properties

Direct investment in properties, either individually or through small partnerships, limited liability companys (LLC), Limited Partnerships or tenancy in common (TIC) arrangements.

Direct investment in Commercial Property offers a number of unique advantages to the investor.

  • Annual write offs against income through depreciation.
  • Sheltering of Capital Gains at the sale through the 1031 exchange.
  • Pass through of much higher amounts of cash flow than REIT's pass through to their investors.

Indirect Investment through Real Estate Investment Trusts

Indirect investment in real estate means purchasing shares of publicly listed and traded REITs - pooled properties and/or mortgages bundled together and offered as a security. Indirect investment, through REITs, also offers advantages:

  • Lower risk - shares in a REIT are traded on exchanges like common stocks and are more liquid than direct property investments.
  • Dividends are greater than with common stocks: between 1995 and 2000, the average dividend yield on REITs (7.3%) is six times that of the Russell 2000 average dividend. Plus, all REITs pay dividends (they are required by law to return 90% of gains to their investors), whereas only about half of common stocks pay dividends.[3]
  • There is no minimum investment in a REIT, and a portion of the dividends paid by REITs can be a nontaxable "return of capital," which reduces the unit holder's taxable income in the year the dividend is received and defers taxes on that portion until the asset is sold.[4]
  • REIT investment has a low correlation in value to that of other financial assets - like common stocks. When stock values are in decline, institutional investors have less spending power, and this depresses value in many parts of the economy - but commercial property often avoid this cycle since its value is tied up in long-term contracts. Because of this, REITs possess low relative historical volatility and provide some degree of inflation protection. [5]

How the Subprime Lending Crisis has Affected Commercial Real Estate

The U.S. Housing Market has been hit hard by issues in the financial market created by the subprime lending crisis. In summary: inflated confidence in housing prices led lenders to give mortgages to unqualified buyers, which led to spectacular short-term gains, and they packaged these "subprime" loans into groups (called collateralized debt obligations) that were traded like securities and purchased by some of the largest investment houses like Citigroup (C) and Merrill Lynch (MER). But when booming housing prices started coming down, borrowers started defaulting on the loans that they never should have qualified for in the first place, and the banks had to write down the value of their mortgage-backed assets. This created huge losses for banks in 4th quarter 2007, and also restricted their ability to borrow and lend capital, creating a credit crunch that has spread into other parts of the economy, restricting consumer spending and creating chaos in the markets for certain types of securities.

But even as the residential housing market bottomed out, commercial real estate seemed to stay above the fray, and prices stayed high. Why didn't the subprime crisis, which had such sweeping effects on seeming unrelated parts of the economy, bring down its first cousin commercial property?

Why Commercial Real Estate May Escape Fallout

  • Commercial properties produce income. The rents and leases of commercial buildings produce a steady stream of revenue for their owners, which only disappears when contracts end or clients go out of business (therefore, during recession, widespread business failures may impact this income stream and underlying property value). Unlike residential real estate income; long term leases, which are common in commercial real estate, allow the property owner to partially offset risk from drastic valuation fluctuations.
  • Builders have Shown Restraint, Avoiding Inflated Supply of Office Space.In the last ten years commercial developers have been conservative in their growth strategies, generally showing restraint in order to preserve property values. Office developers in the top 50 markets are expected to complete 53.9 million square feet of office space in 2008, according to the real-estate data company Reis Inc. While this pace is double the expansion of 2004, it is a slower rate than in historical periods of inflated supply. For example, in the five years prior to the commercial real estate collapse of the early 1990s, an average 144 million square feet of new office space was delivered annually.[6]
  • Commercial Property Values Are Less Inflated (rise slowly), and will fall more slowly than Residential Home Values.Commercial property values are expected to fall in the general economic contraction caused by subprime failure. But Credit Suisse projects that home prices (which have declined substantially from their peak in 2005) will fall an additional 25% to 40% in some places before they finally hit bottom. The average price of a house in the Miami area, which has already fallen around 6%, is expected to tumble an additional 40%.[7] The U.S. Housing Market has collapsed due to failure at each level of its system - from the buyer to the mortgage broker to the real estate agency to the institutional investor - but these failings have been regulated in the commercial sector. Investors in business properties should not expect the same unraveling effect that has decimated the value of residential assets.

Why Commercial Real Estate Won't Avoid Subprime Damages

  • Developers are Staying Away from New Projects. A depressed economic state with declining stock prices and lower spending has led institutional lenders to squeeze credit, and some property owners have been under siege - notably Harry Macklowe who has put New York's Fifth Avenue GM Building on the block in order to appease his creditors. This forces them to sell assets, and a flood of properties for sale means lower property values. That's not good news for REIT investors who will see lower dividends and share prices, nor for direct investors who will have to take a loss or hold onto properties until the market rebounds. Meanwhile, the long-term growth of the market is slowing, as commercial real estate developers suspend growth in response to depressed economic conditions. Rather than developing new properties, firms are opting to sign long-term contracts to keep space occupied, and extending the terms of their existing debt when it comes due rather than aggressively negotiating new rates. This conservative approach means that investors should expect steady rather than explosive growth once the market rebounds from its expected short-term contraction.
  • Institutions will take Massive Losses on Existing Properties. J.P. Morgan projects losses in the commercial property industry will hit $120 billion in the next five to eight years - this is about 4% of the sector's $3.2 trillion in debt outstanding. This is a major loss, but well short of the $200 billion in losses that J.P. Morgan projects in residential real estate, 15% of outstanding debt. So while residential real estate will suffer more, the commercial sector will not be immune as property values fall, buyers remain scarce, and supply out-paces demand. Institutions will suffer from write downs of their assets - Goldman Sachs predicts that Bear Stearns, Citigroup, JP Morgan, Lehman Brothers, Merrill Lynch, and Morgan Stanley will combine for commercial-property-related write-downs of $7.2 billion in the first quarter 2008, following $1.8 billion of them in the fourth quarter 2007.[8]
  • Banks Own Lots of Good Commercial Loans - But They Can't Separate them from Bad Residential Mortgages. In the fourth quarter of 2007, 7.5% of the loans to builders of single-family homes were 30 days or more past due, up from 2.1% a year earlier. Delinquent condo-construction loans rose to 10.1%, up from 2.6% a year earlier. In stark contrast, delinquencies on nonresidential commercial mortgages were 1.6% in the same quarter, up slightly from 1.1%.[9] The stress on small and medium-sized banks created by the failure of residential and condo-construction loans affects the commercial market in two ways. First, the banks are more dependent on the revenues from commercial loans and may even raise interest rates to create additional revenue, if possible. Second, these banks may be unable to lend money to large commercial projects, especially since the credit cycle looks to be in contraction and institutions are hesitant to finance loans and new projects. So the commercial real estate market will be guilty by association - although it continues to uphold its debt obligations at a respectable rate, the failures of its residential relative bring down its borrowing ability anyway.

Recent Activity in the Office Market

Over the past several years, developers completed new buildings at an aggressive pace. 75 million square feet of office space scheduled for completion in 2008, an increase from 53 million square feet built in 2007. However, as economic growth slowed throughout late 2007 and into early 2008, demand for office space remained insufficient in most markets to absorb this new development. For example, the national office vacancy rate increased from 12.5% to 12.6%. Nevertheless, rents and occupancy rates continued to increase over the same time period in the highly competitive markets of New York City, Boston, Houston, and Denver.[10]

So although office landlords haven't dropped rent prices, they will have to find ways to retain customers and attract new ones in an increasingly competitive market. Many firms have started offering more concessions to clients, such as interior construction work and months of free rent.[11] Effective rents, which take into account concessions such as a free month's rent upon signing a lease, were flat or falling in 16 markets in the fourth quarter of 2007, compared with seven markets in the third quarter.[12]

Rent revenues and cash flow from commercial properties is therefore steady, but commercial assets are falling in value. This is primarily because institutions have raised standards and slowed their lending pace, and it is becoming more and more costly to finance the acquisition of commercial properties. Many owners borrowed aggressively from 2005 to 2007, before the residential housing slump, and these borrowers will need to refinance their loans soon. Some won't be able to borrow as much or get the same terms, which puts them at risk of default. Others, however, have seven- or even ten-year terms on their loans, and this time-frame offers ample opportunity for the financial industry to resolve its issues and for the market to rebound.[13]

References

  1. Market Cap Data from yahoo! Finance
  2. SeekingAlpha, "Investing in Commercial Real Estate," 6/18/07
  3. Reitnet.com, "REITs 101"
  4. Investopedia.com, "The Basics of REIT Taxation"
  5. "REITs 101"
  6. The Wall Street Journal, "Malls, Offices May Slump Less Steeply Than Homes," Peter Grant 3/10/08
  7. Statistics by Credit Suisse
  8. Wall Street Journal, 3/10/08
  9. Foresight Analytics, Oakland CA
  10. Realestatejournal.com, 1/8/2008
  11. The Wall Street Journal, 3/10/08
  12. Statistics by Reis, Inc.
  13. Wall Street Journal, 3/10/08

Palm Beach Homes

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