When Scrooge is visited by Jacob Marley’s ghost in Charles Dickens’ A Christmas Carol, Scrooge initially doubts that he is seeing a ghost, blaming the apparition on bad digestion. Scrooge says, “There’s more gravy about you than grave, whatever you are.” After three hauntings, the old humbug vows to change his ways less he be “captive, bound and doubled iron” for all eternity, perhaps even longer.
With the holiday parties before us, and the rotten financial news about the state of Europe keeping investors cautious, perhaps it is time to reflect on change in the commercial real estate industry.
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The economic world is drastically altered. As brainy economist Robert Meulmeester of Cadence Capital Group writes about commercial real estate: “Challenging times are here to stay and we continue our adjustment to the ‘new normal’ as we have yet to really understand what that means, and how you can do business in such an environment… Only once the fiscal and debt impasse have been resolved, a more clearer and optimistic tone will be justified. Capital remains on the sideline as rebalancing has not been completed and sometimes not even started."
I submit for your consideration the following “adjustments” to accommodate the “new normal”:
- We are in a balance sheet recession that likely will limit economic growth for 5+ years. Ubiquitous acquisition strategies targeting 15% to 20% IRRs driven by terminal valuations may not be viable;
- Projections for new tenants in vacant space and lease renewals remain challenging with a potential slowdown in the U.S. economy. Consider focusing your investment thesis on cash-on-cash returns supported by existing leases;
- Segment your asset projected cash flows and handsomely value in-place leases and whack pricing related to vacant space and lease renewals;
- The 10-Year Note and 30-year Bond yields, at approximately 2.1% and 3.1%, respectively, are likely to stay comparatively low. If your projected cash flows are largely dependent on in-place leases, IRRs in the 10% to 15% range may be ample with a conservative capital structure;
- Four and five handle capitalization rates do not work as in most cases cash flow growth will be insufficient to save pricey acquisitions from adverse factors;
- All real estate is local and pricing will vary, but the majority of buyers should be targeting 8 to 11 caps for most non-core properties to accommodate an apparent lack of prospective cash flow growth and the potential of higher interest rates in 5+ years;
- This is a Buyer’s Market. As such, there is rarely need to accept unreasonable P&S contract language that became common during the real estate bubble of 2006-2007;
- Due to capital markets liquidity risks, financing contingencies should include a requirement that banks can and will fund at closing; and
- Shopped deals are now okay. In many markets, the transaction volume is so limited, price discovery created by a brokered deal is necessary for Seller’s to understand reality and not waste your time.
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