Up, Up and Away
With residential real estate crashing and the economy in recession, naturally commercial real estate is going down the tubes as well. But this raised an eyebrow:
Effective rents, after free rent and other landlord concessions, have already started to fall and are expected to decline 30 percent or more across the country from the euphoric days of the real estate boom, according to real estate brokers and analysts.
That is making it all the more difficult for owners, who projected ever-rising rents when they financed their office buildings, hotels, shopping centers and other commercial property.
What on earth could have led people to project “ever-rising rents” on these properties? I could see taking a look at a very specific place — midtown Manhattan, say — and deciding that rents were bound to only go up. After all, Manhattan’s not getting any bigger, and it’s already totally built-out. So as long as the total volume of economic activity in Greater New York rises, so should rents in midtown. Of course a giant Wall Street crash would throw a wrench into that calculation, but the basic thinking is easy enough to follow. But most of the country’s not like that. When rents rise in shopping malls in the suburbs of Las Vegas, people build more shopping malls. There’s nothing wrong with that — the rising rents indicate that there’s demand for more shopping malls. But it would be crazy for a mall builder in that situation to assume that the rents would keep rising forever. The reason the rents were going up was excess demand for shopping malls — demand that the new malls are supposed to be meeting.
Joe Nocera has an interesting story in the New York Times Magazine about why Wall Street’s complicated risk management formulae went bad. But a lot of this stuff, like the “ever-rising rents” on commercial real estate, really doesn’t seem like a very complicated issue to me. Why on earth would commercial rents in general just keep going up forever and ever all across the country?
45 Responses to “Up, Up and Away”
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January 5th, 2009 at 11:26 am
What on earth could have led people to project “ever-rising rents” on these properties?
The PASS syndrome, that’s what.
PASS = People Are Such Schmucks
January 5th, 2009 at 11:44 am
But it would be crazy for a mall builder in that situation to assume that the rents would keep rising forever.
But that’s exactly what they did. Not just CRE developers, but housing developers too. Las Vegas is a great example of a place where dry, hot weather was presumed to be such an asset that everybody in the country would eventually own a McMansion there; and thus fostered a real estate industry that was essentially playing musical chairs with the local economy. Crazy was normal during the Bush era, I suppose.
January 5th, 2009 at 11:45 am
Rule 1 for the newly minted, newly hired MBA or analyst: Make the numbers work.
(Rule 2. Get compensation in form of up front fee — walk away and don’t look back)
January 5th, 2009 at 11:51 am
Bear in mind, again, that what is individually rational during a bubble is often to keep the bubble going and, as bdbd notes, find ways to get paid up front. Precisely because the mathematico-logical models of my marginalist colleagues are radically incomplete, it is quite possible for market values bubbles to rise to a dizzying height above any plausible “fundamental value” …
… and because that is impossible in the marginalist mathematico-logical models, those very models are fine ways to devise fancy sounding cover stories for why the fundamental values really have risen to dizzying heights.
Indeed, the fact that going along with a bubble is often individually is the big problem … that is what creates the individual opportunities that the finance sector was focusing on when they bought one deregulation after another from the Congress, White House and Fed, from the 1950’s on.
January 5th, 2009 at 11:52 am
Why on earth would commercial rents in general just keep going up forever and ever all across the country?
The unrelenting awesomeness of the “nothing bad will ever happen” free market?
January 5th, 2009 at 11:52 am
I think the answer is that it’s easy to go into business or into finance without having a freaking clue about how to discount for inflation. In nominal dollars, after all, it’s reasonable to assume that commerical rents will indeed rise long-term. You just can’t make any money from that prediction.
January 5th, 2009 at 12:01 pm
Of course a giant Wall Street crash would throw a wrench into that calculation, but the basic thinking is easy enough to follow.
Wait, so losing 4000 pts isn’t a Giant Wall Street Crash?
maybe this is sarcasm
January 5th, 2009 at 12:03 pm
Manhattan’s not totally built out. Lotsa holes in Hells Kitchen, East Harlem.
January 5th, 2009 at 12:08 pm
Why on earth would commercial rents in general just keep going up forever and ever all across the country?
This is why you never put optimists in charge of anything. You only have them as a part of your team to keep the pessimists from killing themselves.
January 5th, 2009 at 12:10 pm
What on earth could have led people to project “ever-rising rents” on these properties?
People don’t get tangibly rewarded for predicting a slump, however you will get rewarded for going along with the herd to milk the gains from the short term benefits. Since the 80s short term benefits has slowly infected our economy.
January 5th, 2009 at 12:16 pm
Try being a Wall Street economist and then predict a recession., or a stock analyst and downgrade a stock. It’s a great way to kill the career. Zelman and Whitney are not the norm.
January 5th, 2009 at 12:18 pm
I’m never going to die.
January 5th, 2009 at 12:21 pm
Tom and bdbd come closest. Yes, when one makes projections, one makes them to show that the numbers work. What kind of developer takes projections to a lender showing that the project doesn’t work? I mean, if you can’t get the projections to come out, you need to fine another project or another line of business. There’s usually some scenario in which it pays, and that’s the one projected. And as Tom notes, because of inflation it isn’t crazy to think that rents will rise, not fall. It’s true that doesn’t mean that there’s money to be made, but if the question is whether the principal can be serviced, it’s not a bad start.
Of course, sometimes things don’t work out. And it looks like Manhattan is going to suffer more than most places.
January 5th, 2009 at 12:21 pm
I had a tiny, cheap oceanfront rental condo on a redneck beach in SC and saw no appreciation. Then, in 2005, the price suddenly doubled. I mean, every day, I was logging into Realtor.com in stunned amazement. There was no way in a million years the property could pay for itself through rent. So I held out, white-knuckled, for a while until all my hair fell out, then I cashed out, expecting a price crash in town.
What didn’t occur to me was that if I planned for ever-rising rents, I could justify holding on. I guess I’m not cut out for that work, though.
January 5th, 2009 at 12:34 pm
I’m never going to die.
This is my plan too. It’s working out really well so far.
January 5th, 2009 at 12:35 pm
Re: What on earth could have led people to project “ever-rising rents” on these properties?
Because overall rents have tended to increase, albeit not as frenetically as real estate prices themselves. And yes, there have been periods when rents were stagnant or declining, but the main trend has been up.
January 5th, 2009 at 12:44 pm
Real estate maneuvers mystify me as well. There is a Best Buy store near me. It’s in a high traffic area, the building is large, spacious and appears to be in good repair. The signage inside and out is current and very visible from the road. The parking lot is most often well populated with cars. However, Best Buy is erecting a new building around the corner, maybe 1-2 miles away but still in the same basic shopping area. Retail is struggling, prices are being slashed, bankruptcies abound and there is an abundance of vacant space already available. I’m sure there may be very good reasons to spend the money on this new building, move all the inventory and advertise the new location. It just seems an odd move in the present environment, especially having a current location serving the public but minutes away from the new (!$$$$!) structure.
January 5th, 2009 at 1:03 pm
Steve Duncan, my first guess would be that Best Buy is bumping up against a percentage rent clause, whereby their rents increase with sales at the location. K-Mart used to be notorious for never paying percentage rent at any location and instead would lease another property nearby to keep its sales below the percentage rent trigger.
Others have answered the “why project ever-rising rents”; over the long haul it is true. Inflation in building costs and wages inevitably makes it more expensive to develop new properties, and thus developers wait until rising rents make the project feasible. I do commercial property projections all the time, and currently most of my clients are requesting flat rent scenarios for the first few years, followed by inflated rents.
January 5th, 2009 at 1:24 pm
DTM gets it exactly right. Commercial properties, especially new construction in growth markets, are generally leased for medium to long terms, i.e. 3 to 7 years, with shorter terms for tenants with less credit-worthiness and longer terms for better tenants. The initial lease rate is generally based on prevailing market rents in a given market (mid-town manhattan rents will be higher than mid-town indianapolis, rents near an anchor are higher than in a 20 year old strip mall), and most leases have 2% to 4% annual increases. Most leases are net to the landlord, meaning that the tenant pays all costs of occupancy, including utility costs, real estate taxes, liability insurance, management fee, common area maintenance, etc. In addition, in some retail environments, the tenant pays a base rent plus a share of retail sales above some level.
This leasing practice has been in place for several decades, and despite the current environment, will most likely remain in place. The annual increases reflect inflation, or the anticipation of inflation.
The steadily increasing rent structure is not unusual; how many of you have annual increases in your apartment rent?
January 5th, 2009 at 1:32 pm
Pat, in your scenario Best Buy must have an “out” of their lease available. They exercise it and now the strip mall owner has a large building he must find a new tenant for in a depressed leasing/sale environment. Why wouldn’t Best Buy insist on negotiating a more favorable lease as opposed to the expense and trouble of moving? I know we could bat this particular situation I’m aware of back and forth endlessly. I guess mainly I’m left to puzzle over the vast sums of money, time and various other resources corporations expend doing what they do and whether a great deal of it is really necessary in the final analysis. Especially all the while bemoaning the troubling economics of what they’re doing and and shareholder bitching about the bottom line.
January 5th, 2009 at 1:45 pm
I’m also a bit curious about the “Build a new store up the street” thing. I’m visiting Fort Lauderdale right now, from which city I moved away back in May. There’s a brand new Walgreens open here– just three blocks the location where it used to be found. The only advantage I can see is that the new location is on a major intersection, while the old location was on a major road three bocks from a major intersection. Still, was it really worth the expense of a new building?
January 5th, 2009 at 1:50 pm
“I could see taking a look at a very specific place — midtown Manhattan, say — and deciding that rents were bound to only go up. After all, Manhattan’s not getting any bigger, and it’s already totally built-out. So as long as the total volume of economic activity in Greater New York rises, so should rents in midtown.”
Matt falls into the same projection trap that got us here, that demand always drives supply so cost will always rise. Even before the maximum capacity to increase supply is reached the escalating cost will DECREASE demand because substitution or innovation will occur. Manhattan will, for a certainty at some point, cease to be a high demand area because the physical limit on supply will move the demand elsewhere and existing demand will then migrate to a new supply center. New York as the financial center of the world is a convenience that is becoming less convienient.
January 5th, 2009 at 2:05 pm
After all, Manhattan’s not getting any bigger, and it’s already totally built-out.
They don’t build out, they build up. Plenty more opportunity for developers if the property values/airspace rights are stable.
January 5th, 2009 at 2:59 pm
For Boomers and their children who have come of age over the last 35 years, prices, including rent, have always seem go up, accelearting during the seventies, and slowly decelerating during the eighties and nineties and accelerating slightly again, until the last six months at least. This background inflation has distorted our ability to question price incerases as we just assume it is part of the natural order unless they explode to fast (such as gasoline tends to do). It also made it harder for individuals to appreciate the actual fall in real prices for things that occurred during this period.
January 5th, 2009 at 3:10 pm
Matt wonders:
“What on earth could have led people to project “ever-rising rents” on these properties? ”
One word answer: immigration.
The Census Bureau recently forecasted that the U.S. would add about 100 million Hispanics to the population between 2000 and 2050, due to immigration and high birthrates among Hispanics, especially first generation (3.7 babies per woman per lifetime among immigrant Latinas in California).
So, they’ll all need places to live and shop, so land prices will go up forever, right!
Thus, the Housing Bubble and Mortgage Meltdown were highly concentrated in four states: California, Arizona, Nevada, and Florida.
The problem has turned out to be, however, that Hispanics, on average, don’t earn enough money to pay for expensive land, even after several generations in the U.S. Thus, 50% of the foreclosures in America were in those four heavily Hispanic states, and the great majority of defaulted dollars due to high home prices in California.
Today’s WSJ documents much of what I’ve been saying for a long time, although they skip over George W. Bush’s culpability in promoting easy credit for Hispanics as part of Karl Rove’s strategy of bringing Hispanics into the GOP:
http://online.wsj.com/article/SB123111072368352309.html
January 5th, 2009 at 3:11 pm
the base rent on the most recently signed lease is taken to be the truest indicator of the current market when you’re underwriting loans or shopping your proerty for a loan. since almost all your leases predate the most recent, you project that as spaces become vacant, they will be released at the current market amount. since it is a default under the mortgage if your income falls below a prescribed debt service coverage ratio, the landlord doesn’t have much discretion in reducing rents – there’s no point leasing at rentals that won’t cover your debt service. as a result stores are not rerented once the existing lease runs out and that’s what kills your projections – vacant stores. but it was not a presumptuous assumption when the mortgage was made that future rents would match the higher rents you were already getting.
January 5th, 2009 at 3:18 pm
Notice how political correctness causes stupidity in the markets. Only evil people like me point out that, on average, Hispanics in America have less human capital (e.g., among 4th generation Mexican-Americans, only 6 percent are college graduates versus 35% of non-Hispanic whites of similar ages) and thus less earning capacity and thus less, in the long run, ability to pay off mortgages and credit card debt.
January 5th, 2009 at 3:46 pm
Out here in resort paradise, the landlords seem more than happy to leave retail space empty for a couple of years, rather than do whatever they’ve gotta do to get a tenant in.
It seems counter-intuitive to me that it’s preferable to leave stores vacant rather than – at some point – getting someone in there at least on a short term basis to generate income.
As for “ever rising rents”, the general trend due to inflation is obvious. At issue is the concept that they’d continue rising at a rate greater than the rate of economic growth for the metro area.
January 5th, 2009 at 5:30 pm
Landlords do have discretion about promotions, and that’s why at times like these you will see a lot of “first N months free” deals and other special offers – it doesn’t change their debt service coverage ration.
January 5th, 2009 at 8:24 pm
IMHO, there are two things going on. First, we have not experienced deflation for a very long time. It became at least half-way reasonable to build commercial, finance it with fixed obligations and ride inflation fueled rents gradually up. Many fortunes have been made this way.
Which brings me to the second thing. In essentially all businesses rare big events are ignored. Deflating real estate values is only the current example. Life insurance companies, for instance, price on the implicit assumption that we can never again experience something like the influenza epidemic of 1918-1919. In fact, it nearly a certainty that we will and that perhaps half of the life insurance companies will go broke.
After which, everyone will shake their heads and wonder how they could have been so stupid. But, again, a lot of people got very rich being stupid. And, until the big event rolls around, nobody shakes their head.
All of which is to say that it is always clear what is stupid after the event.
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