Now is a Great Time to be a Major Tenant: Part 2

A few weeks ago I posted about the opportunity for a major tenant to lease at 250 Montgomery Street. A major New York law firm did such a deal last week. From the Wall Street Journal article, Reduction in Rent for Law Firm Proves Patience Is a Virtue:

In 2007, when the law firm of Orrick, Herrington & Sutcliffe LLP began looking for a new location for its New York office, rents in a prestigious building that suited their tastes ranged from a pricey $120 to $140 a square foot.

What a difference two years and a massive global recession make.

Last week, in the largest Manhattan office lease so far this year, Orrick finalized a deal for 220,000 square feet in "Black Rock," headquarters of CBS Corp. at 51 W. 52nd St. The deal provided the law firm with a huge bargain over 2007 prices. Sources familiar with the deal said Orrick will pay monthly rent in the low- to mid-$70-a-square-foot range.

But it gets better. The landlord, CBS, agreed to spend $150 a square foot to renovate the space, leaving Orrick with little to no out-of-pocket costs to set up the new office.

That’s $33 million for tenant improvements the landlord is eating, and capping the rent reduction at 7% trims more that $133 million off the value of the building.

Debacle at 250 Montgomery Street: Now is a Great Time to Be a Major Tenant

GlobeSt.com has a story about the debacle at 250 Montgomery Street in San Francisco:

Realty Finance Corp. of Connecticut has sold its original $47-million loan on a class A office building here for approximately $25 million or $200 per square foot, according to a source familiar with the transaction. The building is 250 Montgomery St., a 15-story, 126,736-square-foot office building completed in 1989 at a cost of about $41 million.

The borrower, Lincoln Property Co., paid approximately $47 million or $405 per square foot for the building in late 2006 and defaulted on the loan in late 2008. Prior to the note sale Lincoln agreed to hand over the property to its new creditor in lieu of foreclosure…

Chris Seyfarth, a partner in Ernst & Young’s transaction real estate group tells GlobeSt.com the pricing of the 250 Montgomery note sale--50 cents on the dollar, just like the Hancock Tower sale in Boston--suggests that San Francisco is no different than any other major metro in that real estate values have plummeted. That having been said, he adds that 250 Montgomery is only 55% leased so it’s hard to suggest that the new price point is definitely 50% of what it was at the peak.

The 57,000 square feet of vacant space represents a great opportunity for a major tenant. Here are the numbers:

In 2006 Lincoln would need to lease the building at rents which would result in net income of $22.25/sf in order to get a 6% return on its purchase price. Based on its 2009 purchase price (47% lower than Lincoln’s), the new owner can get a 33% higher return than Lincoln, and still drop the rents 29%. This is what Jeff Bernstein was talking about in his post on Urban Digs, “Holes in the Dike”:

This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The beneficiaries of this debacle are the new owner, the building tenants, and the tenants in the market who see the new leases at the lower level and push for reductions in their own rent. The losers are Lincoln’s lenders and the owners of other buildings in the market who will be pressured to reduce rents. Lincoln itself appears to walk away unscathed since it looks like they had no money of their own in the deal (read about that here).

Up to now, income declines have been primarily a result of lack of demand. Income declines are likely to get much, much worse as more transactions like 250 Montgomery occur and rents adjust to the new market.

Craigslist Unglues Apartment Rents

After reading John Reeder’s post over on Real Property Alpha about fundamental changes in the CRE market, I started listing some of the changes I’ve been seeing. The first on my list is the effect better information is having on the stickiness of rents.

In the good old days when the market softened you might need to drop your rents and/or offer concessions to rent a vacant unit, but you could rely on maintaining rent levels for existing tenants. Rents were “sticky”; once you got a tenant into a unit the rent level stuck. However, those days seem to be gone, and I think we have the internet in general and Craiglist in particular to thank.

It is now incredibly easy to obtain rental rate information in minutes at no cost. For example, here’s a partial screenshot of the 102 new listings in Seattle posted on Craiglist yesterday renting for between $1,500 -$1,200:

This is obviously a great tool for potential tenants. However, it’s not so great for the owner of the house I rent for me to know there are three comparables houses within a mile renting for $500 to $700 less than I’m paying.

Lack of information used to be a market stabilizer. Now, in 15 minutes anyone can get a handle on a submarket. Renegotiating a lease rate has never been easier.

Seeing Patterns Where There Are None: Geography

Humans are wired to detect patterns, but sometimes there isn’t one. For example, what distinguishes the best and worst performing submarkets in Orange County?

You might focus on geography first; the real estate mantra is location, location, location. Are the best and worst performing submarkets concentrated in a particular area?

Here’s a map, with the five best performing markets (as measured by combined occupancy and rent change) highlighted in green, and the worst ones in red:

Looking at this, you would have to conclude there’s not a pattern; the best performing and the worst performing markets are pretty will mixed up.

The data is for the first quarter 2009 from RealFacts, as reported by Lansner on Real Estate.  Here’s the chart accompanying the story; can you find a pattern in the occupancy and rent changes?

Occupancy and Rent Change News Can Mislead You

When you see a headline saying rents or occupancy in a market has declined, you need to remember you need to consider both rents and occupancy to understand what’s going on.  Lansner on Real Estate reports multifamily rents and occupancy are declining in Orange County, based on a RealFacts first quarter survey. The chart accompanying the story illustrates my point:

Which is the best performing city? Which is the worst?

A few seconds spent trying to answer this question makes it clear; you need to consider both rent and occupancy trends to arrive at the right answer. Costa Mesa is the best performing city, because even though its rent decline was one of the worst, that decline was more than offset by the improvement in occupancy. Placentia was the worst performing market; even though neither its rent nor occupancy decline was the worst, on a combined basis its performance was substantially worse than the other cities.

You might think that occupancy and rent levels move up and down in tandem, and usually you would be right. However, there are actually four possibilities:

• Your occupancy goes up, but your rents go down (see Newport Beach and Costa Mesa). This can happen if you reduce your rents and attract more tenants.
• Your occupancy goes down, but your rents go up (see Buena Park, Laguna Niguel, Garden Grove, and Cypress). This can happen if you raise rents but drive tenants away.
• Your occupancy goes up and your rents go up (no place in Orange County this quarter). This happens in tight markets which are seeing tenant growth in excess of supply additions.
• Your occupancy and rents both go down (all the other Orange County places in the table). This happens when there are fewer tenants in a market (the case almost everywhere today).

So, when you read about a decline in either rents or occupancy, remember you need to consider both in order to understand what’s going on.

CPI and Housing II

I previously posted on the fact that the housing component of the CPI is based on a rent calculation, and not home values.

I just came across an interesting graphic which demonstrates housing is by far the largest component of the CPI. Unfortunately, the description in the graphic of how the housing component  is calculated is vague. Here is the official BLS explanation.

This approach has come in for a lot of criticism. Here is a sample:

Financial Sense University: "The Complete and Utter Failure of Owners' Equivalent Rent"

The Mess That Greenspan Made: "How Owners' Equivalent Rent Duped the Fed"

My Budget 360: "Owners’ Equivalent of Rent: The Fed and BLS Gaming the System"

CPI and Housing

Econompic has some interesting charts on the latest CPI release. Here is a breakdown by major component:

How is it possible, you may wonder, that housing is up around 3% in the last year, during a period when home prices have experienced historic declines? The answer is the housing component of the CPI looks at rent value rather than ownership (there’s an excellent explanation on this Big Picture post).

Housing is the largest component of the CPI. Now that effective rents are falling, it’s very likely the CPI will continue to decline.

Commercial Property Values Down 50%?

The Royal Institute of Property Surveyors says the value of commercial properties in the UK will fall by more than 50% by the end of 2010 (see Guardian article here). Is that forecast plausible? Could it happen here in the US? The answer to both questions is yes.

Income property value is a function of the cash flow it generates. The cash flow has the following components:

• Gross Potential Income (GPI) – This is the total rent the property generates if it is 100% occupied.
• Vacancy/Collection Loss/Concessions – This is a deduction for any unleased space, bad debt, or discounted rent.
• Effective Gross Income (EGI) – GPI less Vacancy/Collection Loss/Concessions
• Operating Expenses – Expenses related to property operations The usual categories are real estate taxes, insurance, utilities, repair and maintenance, management fees, payroll, administrative expenses (advertising, telephone, etc.), and a reserve for capital items.
• Net Operating Income – The EGI less Operating Expenses.

The value of the property is the capitalized value of the NOI, and is determined by dividing the NOI by a capitalization rate (cap rate). The cap rate is the annual rate of return on an all cash purchase of the property. You determine the applicable cap rate for a property by looking at the cap rates of comparable properties which have recently sold in a project’s market (more here if you are not familiar with cap rates).

Here’s an example:

What does it take to produce a 50% decline in the value? Let’s say rents fall 10%, vacancies increase to 15%, operating expenses increase to 55% of EGI, and cap rates increase to 7%. Here is the math:

How plausible is it that such declines and increases will occur? Very plausible – all such changes are well within the shifts which have occurred in previous severe recessions.

Neighborhoods, Disorder, and Real Estate Values

Bad neighborhoods equal bad real estate performance. Most real estate professionals would agree with that statement, but a lot of us feel uneasy saying it, because historically bad neighborhoods have been defined by red lines on maps and linked to the resident’s income level and race. I have touched on this topic a few times before (here and here), but a recent study summarized in The Economist reminded me this is something I wanted to write about in more detail. What exactly constitutes a bad neighborhood, and how does a bad neighborhood hurt real estate values?

My view is as follows:

• A bad neighborhood is a neighborhood where there are visible signs of decline and disorder. These signs include poorly maintained buildings, landscaping, and infrastructure, graffiti, litter, and indications of criminal activity (e.g., drug dealing and use, prostitution).
• Responsible people (which I’ll define in a very limited sense as people who pay their mortgages and rent when due) do not like to be around disorder.
• The aversion of responsible people to disorderly neighborhoods results in less demand for housing in those neighborhoods, resulting in lower values.

I came to this view via Wesley Skogan’s Disorder and Decline and George Kelling’s Fixing Broken Windows, both of which should be required reading for real estate investors, appraisers, and lenders. The latest research provides additional support for the idea that disorder leads more disorder, creating a self-reinforcing downward spiral.

Is approaching real estate investing or lending in a disorderly neighborhood more cautiously really just redlining in disguise? After all, aren’t such neighborhoods typically lower income, and aren’t the residents typically minorities?

One of the findings in Skogan’s research which really struck me was the fact that minorities and low income residents hate disorder in their neighborhoods as much as wealthier and white residents do. The income level and race of residents is not the cause of disorder, and they would be happy to be free of it. If you want to eliminate disorder in a neighborhood, you do it by allocating public funds to maintain and police the neighborhood properly. It’s true that minority and low income neighborhoods often get the short end of the stick when it comes to resource allocation. That’s a public sector problem that will not be fixed by private investment.

Housing Mess Offers Sunshine for Rents: Not

Criticizing Wall Street Journal stories is turning into this month's theme (see my post yesterday re their failure to put the retail sales data in context and Saturday for ignoring seasonality and year over year change in their coverage of housing inventory). Yesterday the WSJ ran a story headlined, "Home Seller's Pain is Renters' Gain" with the lead, "There's one bright side to the housing crisis: some lower rents." The data buried in the story almost totally contradict these conclusions. Here are the key data points:

• The data is from the REIS 4th Quarter 2007 report, which tracks 79 markets.
• In five markets (6% of the covered markets, all in Florida) rents declined since the third quarter. The worst market was Tampa, where effective rents declined 0.6% from the third quarter. The median third quarter rent was $789, the fourth quarter rent was $784, so in the worst rental market in the country median rents declined a whopping $5. There's a renter windfall for you.
• "In 38 other markets including Chicago, Boston, and St. Louis, rents rose during the fourth quarter, but by less than the national vacancy growth rate of 0.9%." Presumably someone at the Journal knows that rents and vacancy are different things, and they meant "national median rent growth rate" (does anyone edit these stories?). Adding in the 5 declining markets, that means 43 of 79 markets had below average rent growth. Not exactly news if you understand what an average is.
• "Vacancy rates fell in 47 of the 79 markets tracked by REIS, and average rents saw their largest fourth quarter increase since 2000." So, we had the largest average rent increase for the applicable period in 7 years, and the headline is "Renter's Gain?"

Charitably, this is a really bad case of seeing the story you expect to see in the data. I've looked at a lot of REIS quarterly reports, and there are always a handful of markets which are down. No doubt there is some mild softening in Florida markets (those same markets where rents spiked because rental units were converted to condos), but it just wrong to present this as a meaningful national trend.

What Do Rents Have To Do with Home Values?

Several of my favorite blogs (see Calculated Risk today and The Big Picture last month) have reported on efforts which attempt to estimate how far home prices are out of whack by looking at historic ratios between rents and home values. There's no question home values are inflated relative to rent levels, but I'm skeptical that the historical relationship has much to tell us about where home values will be over the next few years for several reasons:

1) Historically rents have been much more volatile than home values at the market level (for example, in San Jose during the dot.com implosion effective rents dropped around 25% while home values barely twitched). If rents and home values had much to do with each other it seems like the correlation should be closer.

2) Until the last 5 years or so you could say with a fair amount of confidence the primary drivers of home values were demand (best indicated by employment levels), additions to supply (best measured by new housing starts), and interest rates (lower rates = bigger loans = higher values). Now, we have had demonstrated lax underwriting standards can also lead to leverage-driven value inflation (see my previous post which runs through the numbers on this). None of this has anything to do with rent levels; if anything, rents tend to move in the same direction as home values when the movement is driven by employment and supply changes.

I think the underlying fallacy in associating rents with home values is the belief that people weigh the costs of renting vs. buying and make a rationale choice. No doubt some people do that, but I think most people will buy if it's at all possible and lax underwriting made it possible for more people to buy at higher prices. Even more important, those sales made it possible for everyone who had already bought to leverage up based on the higher values and lax underwriting.

So where will we end up? On the positive side, additions to supply are slowing and interest rates are stable to declining, both positive drivers. On the negative side, if we do slide into a recession the demand vacuum created by employment losses is going to compound the present problem in a really unpleasant way. Rolling 12 month average employment growth is slowing now, and a downturn in that average historically signals a recession with bad real estate consequences (previous post here). The other big unknown and potentially huge negative factor is where mortgage lending underwriting standards stabilize. It was lax underwriting which got us into this mess, and historically underwriting tightens significantly when lenders incur losses. It's entirely conceivable lenders will overtighten and compound the current problem. On the other hand, there will be a lot of pressure, especially on FHA and the GSEs, to keep credit flowing. A recession combined with conservative underwriting will push prices below historical norms. Unfortunately, that seems like the most likely scenario to me.

Impact of Mortgage Crisis on Rental Rates

Calculated Risk has a recent post talking about Housing Inventory and Rental Units. The bottom line of the piece is that most people's estimates of excess housing inventory are too low because they don't consider vacant rental units. It also contains the assertion that home builders have built too many homes. I have a different viewpoint.

A housing unit, rental or ownership, is a housing unit. Most housing units are in 1-4 unit structures, and it is very easy for these units to move from rental to ownership and back again. In recent years large numbers of rental units in even 5+ unit multifamily structures converted to ownership as the buildings were converted to condos. When you talk about overall supply you really need to talk about the whole picture; trying to parse what's a rental and what's ownership is an exercise in futility.

"Too many" residential units happens when there are not enough households to occupy what's been built. It's a topic for a separate post, but I argue that housing demand is closely correlated with employment, and in recent years the number of residential units built has been generally in balance with employment growth. Yes, there are too many homes built in the sense that they're not selling and builders are continuing to add to supply as they work through their pipeline. However, this is a price issue created by the loose underwriting bubble popping. There are still plenty of households who need housing at the right rental rate or the right price and debt structure. Prices will adjust to the necessary levels.

The availability of cheap, loosely underwritten financing unquestionably drew a number of renters to home ownership from rental units (although not as many as you might think, because home values inflated rapidly to accommodate the increased demand such that many renters continued to be priced out of the market). You would expect this would result in more vacant rental units and reduced rental rates. To a certain extent this happened, but the effect was dampened because at the same time some rental units were converted to ownership units, reducing the rental unit supply.

Now, the reverse is occurring; a certain number of owners are losing their homes and becoming renters again. You would expect this would result in reduced rental vacancies and rising rental rates, and to a certain extent it is. However, the effect is dampened because ownership units are being converted to rental units, increasing the rental unit supply.

This interpretation is supported by the Census Median Asking Rent data. This data bounces around a lot and is seasonal, so I think the most helpful way to look at it is as percentage change over a rolling four quarter moving average. It looks like this:

Because this is a rolling average it lags, but what it shows is rent growth decelerated from 2001 through 2004. I believe this started out as a recession effect and continued as renters shifted to ownership. Keep in mind this was not a huge shift, rent growth was only negative three quarters of this period. Since then rent increases have accelerated as owners have shifted to renters, but again the effect is not huge. In fact, a large part of the increase is a reflection of a spike in 4th Quarter 2006 which looks like an anomaly.

My bottom line is the current situation is less about supply and demand and more about a price bubble created by leverage popping.

Will the Mortgage Crisis Lead to Higher Inflation?

The Big Picture has a post this morning suggesting cheap money and slack underwriting put renters into home ownership, and as these owners are foreclosed on they will be returning to rental status. The residential rental market is already fairly tight, and if this shift occurs here is the feedback cycle:

1) More rental demand equals higher rents.

2) Higher rents mean an increase in the CPI. Housing is by far the biggest component in the CPI, and the CPI calculation is based on rent levels, not house values. The CPI did not pick up the escalation in house prices because it focuses on rents and rent increases didn't keep pace with escalating house values. As rents increase the CPI will not pick up the falling house prices.

3) Higher inflation will put upward pressure on interest rates, exacerbating the housing crisis.

There's a scary feedback loop for you.

Ultimately, an equilibrium will be reached as investors buy foreclosed houses at prices which can be supported at market rent levels. That equilibrium is probably years away.