By MARK ANDREW
While transactions and property values ramped up in 2005, again in 2006, and ultimately peaked in 2007, many are looking back, scratching their heads and wondering why that happened.
A recognizable recent shift in the market has taken place and it is important to understand its origin and its current direction.
With the benefits of hindsight, it is simple to grasp the underlying economic building blocks that have created our current investment market. Conventional supply and demand, out of any economics 101 textbook, has paved the way to our present-day real estate buying environment.
As the expanding economy created jobs, consumer spending mounted, investment increased and demand for space skyrocketed. Simultaneously, in the Los Angeles area, land scarcity, soaring construction costs and other barriers to entry kept already restricted supply at increasingly inadequate levels.
At the time, an abundance of capital flooded the market as evidenced through mass privatization and mammoth portfolio buyouts. The national investment audience collectively sat captivated as Equity Office Properties Trust and Archstone-Smith Trust signaled “all in” through their disposition strategies. Arden Realty has repeatedly exercised their local expertise through an exceedingly comparable approach.
Ripple Effect
As buyers of these pricey collections of buildings sorted through their respective inventories, it became abundantly clear that they needed to justify their sticker price. Secondary owners eventually could get their properties to pencil out through rapidly rising asking rates, bulky year-to-year rent escalations and by passing property taxes and other expenses along to their tenants. Tertiary owners experienced carbon copy scenarios but with increasingly emaciated margins as they too played the game.
The universal theme throughout this journey up the valuation staircase has been to rely on the annual bailout of incredible rent growth and asset appreciation. As the market edges closer to its high-water mark, investors fail to recognize that slowed appreciation and sometimes depreciation is silently preying on them from the other side of the peak.
While certainly more cautious than previous generations that also experienced fallouts, investors have proven that they are not immune to memory loss when it comes to basic real estate investment ideologies.
The Southland recently has seen a migration of its tenants moving from the overpriced Westside to areas with more realistic expectations like the South Bay. These economic safe havens coupled with new construction and an overall reduction in demand has seen a regional rise in vacancies which has been foreign to the area in the past five years.
The uncertainty of both the local and national economies has forced regional investors to take a more conservative approach to underwriting deals. As the capital markets are still reeling from the sting of the subprime crisis, increased scrutiny will set in when debt and equity providers analyze potential projects.
This truth has been realized through declining loan-to-value ratio expectations and its inverse relationship to the requirement for larger debt coverage ratios. Recent improvements in the cost of capital through interest rate reductions remain particularly attractive. However, lenders’ risk-related spreads are colossal.
Expectations
As 2008 begins to offset the performance of 2005, 2006 and 2007 those on the sidelines should not expect the bottom to fall out. This scenario will not mirror the “doom and gloom” experienced in the housing market.
Nevertheless, old school principals of investment will return and reign supreme as opportunistic investors and speculative developers have, for the time being, left the building. Buyers have downgraded their optimism and property flippers have been forced to hold their assets or risk substantial losses. Only foreign investment will still be aggressively pursuing an acquisition strategy due to the weakness of the dollar.
Ridiculous growth assumption models and never-ending increases in rents are no longer safe bets from a buyer’s perspective. Thus, landlords likely will see a slowing or flattening of both rental rate escalation as well as property valuation. One can only assume that they will mitigate these downfalls through ever-increasing concessions (e.g. free rent, tenant improvements, etc.). While upward pressure is on capitalization rates and downward pressure is on pricing, those that hold will still benefit from robust leases inked in the most recent past.
Andrew is an investment sales broker in the investment properties group at Studley Inc.
