CRE Commentary

Will technology help obsolete industrial product regain its competitiveness?

All product types face the challenge of obsolescence. Column spacing evolves, office and residential ceiling heights creep upwards (my thoughts on ceiling height here). Clear heights have continued to increase for state-of-the-art industrial product.

One interesting trend that has the potential keep outdated industrial product commercially relevant longer is the growing adoption of robotic picking systems. Lead by ecommerce fulfillment for companies like Diapers.com, Zappos, Crate&Barrel and others, retailers are exploiting robotic order picking from Kiva Systems. While the potential of robots to revolutionizing business ranks just below flying cars and supersonic passenger service in the annals of unfulfilled promise, there seems to be real traction and success with this iteration.

The Kiva Systems technology uses robots to bring shelves to a human picker who then selects the appropriate item. Crucially, the system doesn’t require the same clear heights - in fact the system doesn’t use multi-level racks well - enabling older industrial product to be used. The system is best suited to businesses with a high-number of slow to medium moving SKU’s. It will be interesting to watch how widespread the adoption of these systems will be. 

Green Street CPPI - unchanged at 80% of peak values

The latest Green Street CPPI is unchanged from December up to 81.9 from a low of 61.7. The spread between Green Street and Moody's remains as the Moody's numbers are growing slowly. The 80% is in line with my anecdotal sense of the market and talk around pending transactions.

Anatomy of a Deal: 510 Madison

I previously wrote about the 600 Lexington transaction as an important market indicator. Boston Properties’ (BXP) purchase of 510 Madison is another important bell-weather for the state of the Manhattan market.  Since BXP is publicly traded many of the details of the purchase are publicly available and help paint an interesting picture of the state of the market.

Completed this year, 510 Madison is one of the newest buildings in New York. The building is very well located but esentially empty.

According to BXP filings, the all-in cost totals $375 MM of which $64.3 MM is leasing, TI and interest during the stabilization period.  This works out to $1080 PSF, the first major Manhattan office deal in the one thousand per square foot range since... well according to real capital analytics, when BXP bought 540 Madison for $980 PSF in Aug of 2008.

On the rental revenue side BXP “expects pricing will start in the very high 80s to low 90s at the base of the building and rise from there into the triple digits.”

Using a blended rent of $95 and $30 in expenses gets the Mid-6% yield reported on the earnings call. The market for space in the base of the building along with overall leasing velocity will be the key driver for this asset. The market for tower floors in premium buildings remains strong, one way or the other I expect the demand for the lower floors to be decisive.

Some additional thoughts:

1) Core real estate remainds strong

2) One of the largets owners of office in the country is willing to take leasing risk - worth noting

3) With well leased trophy assets trading around 5% to 5.8% the lease-up risk preimum was around 70 to 150 bp.

The structures of restructuring

While the commercial real estate trade publications and the industry commentariat are rightly focused on the recovery of the capital markets, the efforts of borrowers to restructure their obligations continues. It's important to understand the history of a property and its financing, both to identify new opportunities and understand existing ones. A restructuring lays a new groundwork for the future investment profile of a property. I thought it would be interesting to highlight a few of the common structures that borrowers and lenders have utilized in the current market environment:

1) A Note - B Note: As banks and other lenders clean up their balance sheets, one tactic is to sell loans that are highly liquid, specifically loans with conservative LTV ratios and good cash-flow support. Splitting existing loans into “good loans” and “hope certificates” is one way to achieve this.  Borrowers with over-levered properties will often make an additional equity infusion in exchange for a two-note structure. The existing loan is "right-sized" to a lower LTV and manageable coverage ratios and debt yield. The new equity investment is typically meant to cover additional cash needs at the asset for leasing, etc. and sits behind the A loan and ahead of the B loan in terms of priority. The B loan is usually subordinate to some preferred return on the new equity infusion but remains senior to the original equity. 

2) Increasing the interest rate in exchange for additional term/other modification: At the height of the financial crisis many properties that were able to service their debt (due to extraordinarily low rate environment and a prevalence of IO loans) ran up against a frozen re-financing market. One common modification was the borrower accepting a higher rate in exchange for a term extension. This structure only was effective for properties that weren't over-levered and had solid supporting cash flow.

3) Debt for equity swap: Many borrowers refinanced to take profits as property values increased, leaving assets with unsustainable debt burdens. Lenders, who in stronger markets would repossess a property or sell the debt, were forced into a position where they would effectively take economic control of an asset swapping debt for equity and leaving the borrower with a "hope-certificate" along with, in some cases, a management role and the associated fee stream.  

4) Write-down/Pay-down: The borrower pays down principal in exchange for additional principal forgiveness and extended term.  This scenario clearly requires there to be some existing equity remaining to justify additional capital infusion on behalf of the borrower.

5) Cash flow mortgage: The lender sweeps the cash flows from the property to pay debt service. This structure is used in cases where the cash-flow from the property does not cover existing debt service.

6) Discounted Pay-off: In cases where the lender is willing to sell the loan at a deep discount, the borrower may benefit from buying the loan outright.  This scenario has not played out as often as initially thought in this downturn as banks have been hesitant to blow out positions at the market bottom and have instead preferred to wait for at least a marginal recovery in pricing.

Fundemental Driver - Employment Data

Almost definitionally, one of the key drivers of the U.S. office real estate market is job growth. To be sure, trends in the demand for space-per-worker impact total demand, but fundamentally, job growth creates demand growth. The most recent employment data showed an increase of 151,000 non-farm jobs in October, the first monthly increase since May. While encouraging, the rate of gain will need to accelerate if top-end forecasts - estimates the U.S. economy has the potential to add 3-3.5 M jobs a year for the next 3 years - are going to be hit.

One reason for optimism, productivity growth is slowing down. Counter-intuitively, this can be a harbinger of job gains as the current workforce is already producing at capacity and new production must come from new workers.

The following chart from Calculated Risk underscores the depth of job losses and the potential job gains that will bring us back to parity.

  

 

 

Links of the week

1) The Wall Street Journal: Real estate investors are moving from opportunistic real estate funds into core real estate funds.

2) Taking the abuse of free parking to new levels. One homeowner parks 50 cars on the streets near his home. http://www.marginalrevolution.com/marginalrevolution/2010/11/-the-high-cost-of-free-parking-continued.html

3) Do we want urban spaces that are big or small? Spread out or compact? New or old? Witold Rybczynski has an interesting new article in Slate on what type of cities people demand.

4) At the bottom of the cycle it's often hard to identify where new jobs will come from. The technology sector is one that is rebounding well. Salesforce plans would quadruple S.F. space

"We live in a relative world"

I have started to hear the phrase "we live in a relative world" or similar sentiments much more recently. A "relative world" is shorthand for thinking about real estate as an asset class that competes for capital against other invest-able assets. It's an argument for pricing real estate in comparison to other assets and not on an absolute basis.

The most common point of comparison is Baa bond yield. The Baa rating is used as a proxy for the credit of a typical commercial real estate tenant

Two issues to note:

1) Spreads can close from either side. A large spread to Baa rates doesn't imply further cap rate compression any more than it indicates overpricing of bonds or overpricing of both bonds and real estate vs. equities.

2) The competition for capital goes beyond fixed income investments. Of course, most commentators acknowledge this, but when you hear "we live in a relative world" it's almost always followed by a discussion of the 10-year treasury and Baa rates. Equities matter. As an example, Green Street advisers finds real estate underpriced vs fixed income alternatives and overpriced vs. stocks.

 

J.C. Penney - Pershing Square and Vornado

Vornado and Pershing Square recently disclosed a 9.9% and 16.5% stake in J.C. Penney respectively. The disclosure recalled the glory days of the Op-co/Prop-co structure and hinted at its return.

One aspect to watch if this transaction progresses is the lease structure between the Op-co and the Prop-co. Given that TIPS just sold with a negative yield  - I would expect the lease to be structured with a CPI escalator designed to tap demand for inflation protected investments.

Pershing Square was contemplating a similar structure with Target - creating a single tenant REIT with an inflation protected lease, but the transaction did not materialize. 

Green Street Advisors - Commercial Property Price Index

The most recent Green Street CPPI showed commercial real estate values have increased almost 30% from the bottom in 2009. Green Street notes three factors that contribute to this increase. 1) plunging return hurdles (this is clearly the case), 2) dearth of distressed sellers... true so far, although there are indications this is changing going forward and 3) Recovering fundementals in some markets... Hotels being notable for their recover, while many office markets, while stabilized aren't yet showing "quicker-than-expected" improvements on the opertaing side.

 

Thoughts from Zell Lurie - Transaction Volume

One of the key themes that emerged from the Wharton Zell-Lurie Real Estate Center conference this past Tuesday was an expectation of increased transaction volume for properties that are controlled by lenders. While these transaction have been “expected” for some time now, the funds that have been raised to target them are still waiting. Many of the panelists noted several factors that will drive these deals:

1) Lenders have built up sufficient reserves to work through losses associated with distressed assets on their balance sheet. Since bank borrowing costs have been historically low, lenders have, through their net interest margins, been able to recapitalize through operating profitability.

2) There is substantially more certainty for sellers taking distressed assets to market. The ability of potential sellers to “know what they are going to get,” compared to a market where the bid for distressed assets was unknown, will drive increased volume.

3) Paradoxically, as fundamentals recover, new TI’s and other capital burdens will squeeze marginal properties and owners. Banks were willing to extend term and grant other concessions that did not require additional capital, but once a project requires new capital they will be unwilling to fund. This will likely create a leader driven transaction or an opportunity for a Mezz or preferred equity investment.

Links of the Week

1) An interesting commercial real estate blog: Vanilla Shell

2) Good reasons to phase out the penny.

3) Felix Salmon on Basel III

4) Perhaps the most prominent New York venture capitalist's thoughts on real estate.

Parking - San Francisco's new system

San Francisco has implemented a dynamic pricing system for street parking. Here is the site. Paramount owns the parking garage at 75 Howard Street and it will be interesting to see how demand changes based on these new rules.

The initial pilot replaces the meters in 415 financial-district spaces (a similar number to the 75 Howard Garage as a point of reference) with dynamic meters that adjust prices up and down with the goal of keeping one free space available per block. The price of street parking in the financial districtwill increase substantially (as the system balances supply (low) with demand (high)). Street parking will be more available but priced much closer to garage spaces.

Parking - pricing and minimums

There has been a lot of discussion on parking and minimum parking requirements in the last week. I discussed some of the issues in a previous post. There are several issues that are often grouped together. The first is legal minimums -here is a recent paper that finds, unsurprisingly, minimum parking requirements significantly increase the amount of parcel area devoted to parking.

It is important to note that in a suburban setting many retailers have contractual minimum parking requirements independent of zoning and these requirements result in a large number of unused spaces for most of the year. Tenant requirements are not sized for "most of the year" and are in place for key shopping seasons like the end of the year where available parking is vital. Some commentators advocate charging for parking in these situations, however, the cost of providing this parking is reflected in the cost of occupancy and thus the price of the goods.

The second issue is subsidized free parking provided by cities.

Tyler Cowen has morein this post.

Additional commentary from O'toole. Although he is wrong about free parking in Manhattan, it indeed does exist as anyone who has watched the alternate side ballet can attest. Of course driver essentially camp in their cars waiting for these spaces to open up since they are priced so far below market.

Interest Rate Impact on Housing

Glaeser, Gottlieb, and Gyourko have a new paper analyzing the impact of interest rates on housing price appreciation.While lower interest rates clearly have a positive impact on pricing, the magnitude of that impact is hard to determine exactly. This study finds a lower importance than previous work as it adds an expectation of mean reversion in rates. I am not sure that even if a home buyer looked forward with the expectation of increasing rates they incorporate that into their expectation of pricing. That now may be the case, but in the past the expectation of price change was independent of interest rate change - buyers assumed prices went up, sometimes more slowly, but they went up.

Links of the Week

1) Great overlay of the historic plan for Washington D.C. and a current map.

2) It is always interesting to read Thomas Barrack's thoughts on the market.

3) For interesting discussions on economics and economic principles in other areas of life. Marginal Revolution is one of the best daily sources out there.

4) I use Calculated Risk as a source for a number of finance graphs and the site is a good clearing house for housing market data.

Chinese Housing Bubble

There is an interesting new paper out from Jing Wu, Joseph Gyourko and Yongheng Deng on the Chinese housing market. The FT covers the paper here. The headline number of 800% growth since 2003 jumps off the page.

Although the paper doesn't go so far as to declare this a bubble - I discussed the Chinese housing market with Prof. Gyourko a few months ago - his take "a bubble - no question."

Looking at these data I would have to agree.

Wall Street Journal - behind the curve on "extend and pretend"

I needed to re-check the date on yesterdays Wall Street Journal article on lenders "Extending and pretending" The article isn't wrong - deferring maturity dates and rolling existing loans has been an important tactic for many lenders - the timing is off. Many lenders have been implementing some form of this strategy for almost two years and I believe the tide is actually starting to shift the other way. There are at least three factors that play a role:

1) Improved values make recovery rates more certain if a lender takes a property back.

2) The widespread acquisitions of special servicers may signal a shift in operations for the securitized segment of the market.

3) Improved bank balance sheets allow more lender flexibility in dealing with distressed loans.

Paramount Group - Manhattan Island Marathon Swim

I wanted to take the opportunity to thank Paramount for their sponsorship of my team for the Manhattan Island Marathon Swim. The swim was a 28.5 mile counter-clockwise circumnavigation of the island of Manhattan on June 12th.

The Paramount team had a great day in the water and ended up finishing in second place.

Yuan to float - Real Estate Impact?

As predicted in this post. The Chinese government announced today that they would let the Yuan "float" in a limited way. What are some of the potential impacts for real estate:

1) On the retail side there may be an increase in costs for retailers which could hurt retail owners.

2) Treasuries yields may rise as the demand for Treasuries, driven by Chinese purchase to keep the exchange rate constant, eases a bit.

3) The policy, in general, can be seen as a sign of strengthening in the Chinese economy.

Green Street CPPI

The Green Street Index showed a small increase in May and has increased 20% since the bottom. This marks another month the Green Street Index has diverged from the Moody's Index.