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Investing in Los Angeles County Commercial Property
Tony: How long have you been involved in the real estate industry?
Bill: I have been involved in the real estate industry for over 15 years. I began my career as a retail leasing specialist for Jon Douglas Commercial brokerage in West LA. I moved on to become a Site Acquisition/Project Manager for AT&T and Sprint in building out their cellular networks. I then went on to become a Financial Analyst for a real estate hedge fund based in Hong Kong. I also have experience as a single family residential developer with projects on the east coast. I have been in my current position for over a year.
Tony: What is your current focus?
Bill: Currently I’m an Investment Consultant with DC Commercial Inc, in Century City. I specialize in the shopping center and office market segments with a particular focus on the Mid-Wilshire, Hollywood, downtown LA, and West LA submarkets. I also have experience with the multi-family market place.
Tony: It has been my observation that the peak year for residential sales in the South Bay was 2002, but that the peak year for average sales prices came later in 2007. Once the credit market crunch hit, the number of homes selling and their price points dropped off quite a bit. Has there been a similar pattern in the commercial space?
Bill: The commercial real estate market peaked in the 3rd qtr of 2007. As with the residential market place, very loose lending standards along with lax oversight resulted in many loans being originated that should have never been made. Many of these loans were the direct result of the commercial real estate market being securitized. The evolution of the commercial backed mortgage security industry created a market where by commercial loans could be made and then sliced up into marketable securities that could be sold to investors through the capital markets. As such, banks were not required to carry these loans on their balance sheets since they could sell the loans to the Wall Street syndicators who would package them up and then sell off pieces as securities that were sold to many individual investors. These instruments functioned much like corporate bonds in that they paid an annual interest rate. Instead of the securities being guaranteed and backed by the assets of a corporation, they were backed by 1st lien position that the mortgages would have on the real estate property. Since the banks did not have to carry these loans on their books, the underwriting standards used were very loose and in many cases reckless. Policies such as interest only, Loan to Value ratios in excess of 90 percent, overly aggressive assumptions regarding future rents and values, and non-recourse were widely used and implemented.
Tony: Can you put this into a broader context for us?
Bill: These policies combined with the worst recession in decades have significantly affected the commercial real estate market place. In many instances prices have fallen 50 percent since the 2007 peak. In Los Angeles County, deal volume was off 85 percent in 2009 compared with 2007. Rental rates for all asset classes are declining and vacancies are rising. For instance, in the west Los Angeles sub market, one of the region’s biggest and most desirable, the vacancy rate has tumbled from 13.6 percent in 3rd qtr of 2008 to over 22 percent in the 3rd qtr of 2009. Rental rates have dropped over 10 percent from an annual average rate of $47.63 to $42.47. In other less desirable areas, the resulting deterioration has been even greater. In many instances, the loan balances are higher than what the prices are currently worth.
Tony: What will it take economically or politically for the Retail and Office segments to turn the corner?
Bill: The road back will be a long and difficult. It is estimated that there are $ 2 trillion dollars of commercial mortgages that will be need to be refinanced in the next two years. There are estimates that only 35 percent of these loans will be able to be renewed. This will mean that the banks will be foreclosing on the properties and as a result flooding the market with additional inventory. Since the banks do not want to carry non-performing assets on their balance sheets, they will price the assets to sell, which in turn will further depress values.
Tony: If you were to take a guess when this might happen, what would your guess be?
Bill: Moving forward, the biggest catalyst to a recovering market will depend greatly on the economic landscape, particularly as it relates to employment and job creation. The unemployment rate directly impacts both the Office and Retail segments substantially. If people are being laid off, companies do not need as much office space which results in lower demand, higher vacancies and lower rental rates. Likewise, if people are being laid off, they do not spend as much on shopping which hurts retailers and in many cases puts them out of business. This results in retail vacancies. Some good examples of recent retail failures include Circuit City, Mervyn’s and Linen & Things. In addition, an improvement in the lending environment will also be a contributing factor to any recovering. The pendulum has swung 180 degrees as it relates to lending standards. The lax standard of a few years ago has been replaced by overly restrictive policies which in many instances makes obtaining a loan nearly impossible. The U.S. Government bail out of many financial institutions was supposed to provide liquidity to the banks so that they could go about the business of lending. In many cases, these banks have been hoarding the funds. We need to see the banks start making loans with more favorable terms.
Tony: Is there anything more that you would like to add?
Bill: As mentioned above, there are numerous factors which will contribute to the recovery in the commercial real estate market. A lot will depend on the economy and job picture. The lending environment will be an important driver as well. The situation with the upcoming refinancing of such a large pool of loans will be a factor as well. It is my opinion that there should be some type of program put in place similar to the RTC in the early 1990’s where by all non-performing assets are grouped together under one entity and priced to sell. This would allow the banks to “clean up” their balance sheets and resume lending since they would not have to worry about setting funds aside to cover or offset the problem loans. This would also establish a “floor” in the market which auction style pricing would establish which in turn would give investors, which there are many on the sidelines, the confidence to invest in commercial real estate without the threat of a looming tidal wave of foreclosures to hit the market in one, two or three years. It would establish “certainty” which all investors want.
As far as timing goes, it is hard to pinpoint when things will recover. Commercial real estate cycles tend to be years in the making. The last severe real estate recession, 1990-1992, did not see a recovery until 1997. That said, for patient investors, this is one of the best times to be buying commercial assets with the caveat that an investor has to have a five to seven year time horizon. In addition, it is my opinion that the interest rate environment will never again be this favorable. Inflation and higher interest rates sooner rather than later is a guarantee. Thus taking advantage of interest rates in the 6 percent range is going to prove to be a very wise decision by savvy investors.
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