The credit crunch in the residential real estate market has caused panic on Wall Street, a sharp decline in home sales and record foreclosures. However, a similar total melt down has not occurred in the commercial real estate market. Having said that, there is a definite credit tightening for commercial loans and heightened underwriting scrutiny for mortgage applications. So, is now the time to look at investing in commercial real estate or will there be a similar value crisis for commercial properties?
The answer is a definite maybe. While most financial professionals think it unlikely that the commercial real estate market will fall as far as the residential market has, most will acknowledge that a price adjustment of 10-20% would not be unexpected. And in some sectors, such as retail, the fall could be dramatic.
Notably, some big developers hit a big bump in the road and faced well publicized forced sales when they were unable to refinancing large trophy properties. But this has been brought about by the credit crunch in the CMBS (commercial mortgage-backed securities) market, where very large loans were sliced and diced and sold off in pieces to syndicates. When the sub-prime market imploded, CMBS money virtually dried up and those whose loans came due were in a really bad spot, with few affordable options to bail them out.
For properties under $5million however, local and community banks, who traditionally do not securitize mortgage loans are still lending to qualified buyers, albeit with a closer eye toward strict underwriting fundamentals, conservative pro formas for future cash flow estimates and personal guarantees from the borrowers.
The key to purchasing commercial property today lies in understanding basic valuation and underwriting standards. And, with some experts predicting as much as a 25% drop in commercial property values in the next year, there may be some golden opportunities for well-capitalized buyers to enter the market today. Here are some things to consider.
Equity: Lenders want to see some skin in the game. Gone are the days of 100% financing. Lenders today will require at least 25% down. Since fewer investors have that kind of ready capital, competition for acquiring properties will not be as heated as it was in the past few years. Well-capitalized investors will have better bargaining power and can negotiate more effectively. Multiple rounds of bids for properties are a distant memory.
Realistic Pro Formas: Historically, (at least for the past decade) cash flow pro formas have estimated ever increasing rents of 4-6%, or more, a year. With recession clouds covering the horizon, and increased costs of, well, just about everything, businesses will be hard pressed to swallow big rent increases in the next few years. In many markets, vacancy rates are trending upward. Faced with the threat of having an empty building, landlords will reduce rents to keep paying tenants in their space. When underwriting a prospective acquisition, it would not be unreasonable to anticipate flat or even declining rents when calculating net income.
Location and condition: Now is not the time to be betting on marginal locations or properties in poor condition. When markets decline, there is a "flight to quality" by tenants. If rents are declining, businesses that are doing well will seize the opportunity to trade up to class A space and leave marginal locations and battered buildings behind. Given the ever-increasing cost of transportation, buildings with access to public transportation would provide better options for tenants.
Knowing your lender: One of the benefits of doing business with a local or regional bank, or an experienced local mortgage broker is that you can have a conversation with a loan officer. Take time to understand their underwriting criteria, the type of property they like to finance, the equity they require and what "reserves" they typically apply. (Reserves are hold backs from cash flow that are placed in escrow accounts held by the lender to fund anticipated capital costs that might occur during the life of the loan - e.g., a new roof, or a HVAC system.) Knowing how lenders underwrite a property will assure you will be able to get the financing you need when you are the successful bidder.
Experience: If you are a first time investor, frankly, it will be more difficult to get the financing you need. Lenders are not only betting on the value of the property today, but also maintaining that value throughout the life of the loan. All things being equal, an owner who has successfully owned, operated and maintained a good track record for managing investment properties will have better negotiating leverage with a lender. Without experience, lenders may look for additional collateral before providing funding.
Since no one ever sounds a gun when a market has hit the bottom, it is difficult to say exactly when things will turn around and start back up. But, all things considered, smart investors take advantage of economic slow downs to position themselves for recoveries. Odds are, a recovery for the current market recession is a couple of years off, but, with careful underwriting, examination of the staying power of the in-place tenants, and effective management of the property wise commercial real estate investors will weather this storm and come out in good shape.
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