Adaptive/Re-Use and TOD - Class 9

Adaptive/Re-Use

A trend that has encompassed many sectors of real estate has been adapting and re-using buildings for a variety of uses. Warehouses are being converted into loft apartments. Grocery stores are transformed into charter schools. Churches have even been converted to breweries. This sweeping trend has taken old dilapidated un-used buildings and converted them into buildings with a new purpose.


The benefits of adaptive/re-use are innumerable to not only the building owner but also to the local market and the city. Residents see an improvement to their neighborhood as well as an increase in property values. Cities benefit from increased tax income. The property owner benefits from financial incentives from the city, potentially lower construction costs and entry to the market, and an architecturally unique building, in most cases. Furthermore, the adaptive/re-use method is a sustainable one that doesn’t require additional resources that are required to build a building from the ground up.

The challenges with adaptive/re-use are plentiful. The prospective project may have certain legal and zoning hurdles not to mention significant environmental hazards such as underground gas tanks. Moreover, adaptive/re-use projects are limited to the existing physical characteristics of a building and may have structural issues that restrict the use of the project.

Adaptive/re-use projects are an important part of the real estate industry and provide an opportunity for forward thinking adventurous developers. They also convert oft forgotten areas of cities into vibrant and unique neighborhoods.

Transit Oriented Development

As residents desire a lifestyle less dependent on a vehicle, the real estate responds in kind with a new style of development – one that is dependent on public transit. This development is known as transit oriented development (TOD). It combines various sectors of real estate that create convenience for the consumer. A variety of retail, restaurants, commercial office, and residential units are built around modes of public transportation such as rail and bus. The goal is to provide the consumer with essentially everything thing they could need while having access to other parts of the city, or cities, via public transit. TOD’s also aim to reduce the use and dependence of personal vehicles.

Such developments are becoming numerous across the country as the trend catches on. However, they may not succeed in every market. Dallas’ most prominent TOD, Mockingbird Station, has had a mixed reception. By most real estate accounts it’s considered a success. Residential units remain occupied; the address is desired by office tenants and consumers flock to the many shopping and dining options. Ironically enough, the DART rail system is generally an afterthought since most occupants and users arrive via a personal vehicle.

This is not to say Mockingbird Station has been a failure, it’s anything but. The question now becomes is the success related to being TOD or because of the already strong neighborhood. If the DART station was fully removed would Mockingbird Station cease to exist? Unfortunately, that answer is no. Mockingbird Station is situated a mile north of downtown Dallas on a major highway and surrounded by many affluent neighborhoods such as Highland Park, University Park, the M-Streets, Knox-Henderson and Lakewood. The DART station contributes practically nothing to its success. Its success falls back on the age old answer of how to succeed in real estate – location, location, location.

Furthermore, residents of the prospective TOD must be willing to embrace a non-car lifestyle and I don’t think Texans are quite ready to give up their vehicles. Cities such as Portland, Vancouver, Seattle and Edmonton are prime examples of cities who embrace the TOD lifestyle with open arms.


I am all for TOD’s as long as the TOD fits the needs and wants of the surrounding residents or even provide more incentive to abandon the personal vehicle all together.

Residentail Trends - Class 8

Residential Trends

Are consumers tired of suburbia? Does suburbia still have importance (Think education, space,) Is suburbia still relatable to the American dream?

Once forgotten, downtown living is now becoming important again. This surge is coming from a variety of sources such as empty nesters, young professionals, and married couples. Even though they have their own varying reasons, they are looking for the same thing. These would be trend setters are seeking smaller livings spaces, walkability, less home maintenance, cultural havens, and convenience.

Empty nesters are no longer interested in maintaining large 3,500 square feet homes. They are opting for smaller 1,500 square foot condos. By doing so, they reduced their utility bills, reduced the need for excess furniture, and no longer need to maintain a lawn or a pool. Instead these amenities are included with condominiums and apartment communities. Additionally, these condos can act as a secure “home base” in a way that allows them to travel without worrying about a house.

Young professionals yearn for downtown living due to the proximity of their workplace and entertainment. Downtown’s generally offer a variety of dining and entertainment options that are usually not found in the suburb. Young professionals are also able to live in close proximity to like-minded people.

The modern family has also shifted in favor of downtown living, at least until they have children which is happening later in life. As young professionals marry, they still desire the downtown lifestyle and its many perks. These families, as a result, are having children later in life than their parents. For example, by my mother’s 31st birthday, she was having her second child and living in her third home. Contrast that with myself - 30 years old with no children and living in a downtown environment. My friends who are having children are doing so in their early thirties and then choosing the suburban lifestyle of larger homes, better schools and a sense of security.

This large shift in consumer change has had a significant impact on real estate as more companies focus their attention on creating a live-work-play environment that encompasses these new desires. Cities are now challenged to make their communities more livable and more attractive. Companies are now blending commercial, retail and residential in an effort to bring back art, entertainment, and culture to downtowns. This is not to say suburbia is dead or that it’s on life support. It’s just evident that the American dream may no longer require suburbia.

It will be interesting to see how long this change will last. I feel downtown areas will become crowded once again and lose their appeal. Right now the idea of downtown living is new, fresh, and different. The question is how long until it becomes stale because, as we know, consumers are fickle creatures.

Property Valuation Changes

One impact of the economic downturn is how appraisers evaluate property value and what influence rental concessions may have. Tenants have had the upper hand when it comes to lease negotiations and eager landlords desperate for occupancy have given up months of free rent as a result. It’s not uncommon for a landlord to forego one year of rent simply to sign a tenant to a long term deal but how does this impact how an appraiser views a property?

Appraisers are now faced with using market vacancy or economic vacancy when valuing a property. As a result of the various concessions landlords use, this question has become increasingly difficult to answer. The economic vacancy method may be the truest since it takes into consideration all factors that impact a property’s value when using the income approach the value. Whereas the market vacancy method does not consider any concessions a landlord may have given to prospective tenants.

As an end result appraisers may be over inflating a property’s value simply by not including the lost income from concessions.

Emerging Markets, Private Equity and Investing - Class 7

Emerging Markets

As the US real estate market continues to struggle, there are a variety of emerging markets that are catching the eyes of investors. The tops markets ripe for real estate investment are Brazil, China, India, Vietnam and Mexico. These markets share many factors in common that position them to be fit for investment while at the same time provide certain challenges.

These common themes are a growing middle class, increased housing demand, government subsidies for low income mortgages, increased demand for consumer products, and a low labor cost. The challenges are quite predictable when dealing with an emerging country. They include higher risk, political unrest, lack of liquidity, limited access to capital, a lack of corporate transparency, and rising inflation and cost of living. However, there are benefits to the investor which include a potential for higher return, portfolio diversification, and access to raw materials and cheap labor.

The most important factor in emerging markets is the explosion of the middle class. This rise is what drives demand for housing and consumer products. For example, Brazil’s middle class had an estimated 35 million people join between 2033 and 2009, and an additional 20 million are expected to be included by 2014, according to CNBC. Furthermore, Brazil’s unemployment is relatively low at 6.5 percent. This growth means nothing but dollar signs for the real estate market and economy as a whole.

Also, Brazil is gearing up for the 2014 World Cup and 2016 Olympics. These international sporting events will spur growth mainly in infrastructure but also the retail sector. Investors are knocking down the door trying to position themselves for the upcoming games.

Private Equity

As the real estate market regains steam in the United States, private equity funds may be left in the dust. Real Estate Investment Trusts (REIT’s) are positioned to act fast when an opportunity presents itself simply because they have access to large amounts of cheap capital. However, private equity funds face certain challenges.

First being the high cost of entry. These funds are largely seen as an expensive way to access the real estate class. For example, fees and expenses for Opportunistic Funds, the most risky, average 226 basis points (2.26%) while core Funds, the least risky, average 107 basis points (1.07%) for entry. Compared to typically entry via a REIT where expense ratios can be as low as 13 basis points (0.13%), or lower.

Secondly, the lengthy lag time to acquire private equity funds. As private equity fund managers spend their valuable time acquiring the necessary capital to purchase assets, the opportunity may already be missed or even purchased by another fund.

This is generally good news for REIT investors since they have a leg up. Private equity funds will continue to face these challenges going forward as investors are wary if investing in these funds.

Investing

Apartments are the hot investment class among investors at the moment. 2010 showed record growth in the multifamily sector as American’s, scared of the housing market, elected to rent instead of buy. Renters enjoy the benefits such as not being locked into a 30 year mortgage, paying no maintenance expenses, no longer need to spend hours repairing items, and greater flexibility in terms of size and location.

The multi-family market is responding with rising rents, fewer rental concessions, and new communities. Investors are paying top dollar for existence communities in major gateway cities as well as sites poised for strong growth. Lenders are also loosening their purse straps for ground-up projects in core markets as a response to sound fundamentals and strong interest from investors.

Axiometrics Inc., a provider of data and analysis on the multi-family housing sector, estimates that effective rents will rise 5.9% in 2011, which would be the largest annual increase since a rate of 5.8% in 2005. The top performing major markets for annual effective rent growth in May included San Jose (13.0%), San Francisco (9.7%), Austin (8.7%), Seattle (8.5%), Boston (7.4%), and Dallas (6.5%). Axiometrics predicts effective rents will continue to rise throughout 2011.

However, owners and investors preparing to enter the market in the near future may be too late to the party as the return on investment may prove to be less than those in the market in late 2009 and 2010. As large sums of money are entering the market, acquisitions prices are soaring. Capitalization rates are progressing south of 6.00% for core markets.

The question remains though, how long will the multi-family market continue to heat up and will the market become overpriced and over saturated? Furthermore, will consumers, who are used to large houses, prefer the simplicity of apartment living? The answer to that question will remain to be seen.

Lending and Financing Trends - Class 6

Lenders Force Deferred Maintenance

One effect of the rise in foreclosures is the glut of commercial buildings banks are forced to take back. For the past few years commercial property owners opted to spend less on maintenance of the building and using these cash reserves for things such as mortgage and tax payments. However, as times get tougher, tenants downsize or out right move out, and mortgage payments are missed, owners are less inclined to worry about deferred maintenance items. Now that banks are slowly taking back these properties, they are forcing owners to stay current on preventative maintenance and building upkeep.

This issue for the banks is they are getting these buildings back in much worse shape than they had imagined. Some owners have completely neglected their property simply because they know they are headed to foreclosure so they have no incentive to maintain the building. This has forced banks to get tougher during their annual inspections of properties. Most loan documents have certain requirements for the owner to maintain the property at a certain level. Typically these clauses aren’t enforced since owners understand the importance of upkeep in attracting and maintaining tenants.

Furthermore, if a building owner elects to refinance their loan, banks will look harder at the property to assure it is being properly maintained. Should an owner not wish to replaced damaged windows or repair roof leaks, the bank can simply reject the refinance offer until these items are repaired.

The last thing a bank wants is to own real estate, especially real estate that requires time and abundant maintenance.

Interest Only Loans Are Back

Many real estate professionals felt part of the reason for the real estate downfall was the issuance of loans with interest-only periods. This was a concern because when the interest-only period is over the monthly payment skyrockets once principal is included. Few can predict the cash flow of a commercial building a year or two down the road, especially if a significant tenant goes dark leaving a huge loss of income. This creates a catastrophe if the expiring interest-only period coincides with decreased income.

In the first quarter of 2011, reports show that interest-only loans are back in demand. A full 24% of the loans that were securitized in the first quarter of 2011 were structured with some sort of interest-only period, according to John B. Levy & Company. It begs the question if history will repeat itself and we are heading towards the same cliff.

Quiet End to “Extend and Pretend” in Commercial Lending

One are of contention in the recent real estate downturn has been the reluctance of lenders to outright foreclose on defaulted loans. Investors argue the lenders preferred method known as “pretend and extend” is only prolonging the downturn and delaying the recovery. However, banks are quietly putting this method to bed.

Today, lenders are foreclosing on roughly 70% of troubled loans and modifying only 30%. This is a change from roughly 80% of troubled loans being modified in 2009.

Additionally, the market has seen a rise in real estate buyers who are hoping to purchase distressed assets at pennies on the dollar only to flip them for a substantial profit. This increase in cash flow in the market has caused prices to rise 4.2% since August 2010.

Hospitality Trends - Class 5

The recent economic downturn has caused consumers to evaluate their priorities when it comes to vacationing thus impacting the hospitality market. Many consumers opted for “stay-cations” whereby they were tourists in their own cities. This depleted the hotel industry as many rooms stayed vacant for extended periods of time. The question now becomes what are penny-pinching consumers looking for when they travel and will wary hoteliers respond?

One trend for hoteliers to rid of vacancy is through member only websites or “flash sales” such as Rue La La, SniqueAway, and Groupon. This allows hotels to discount unused rooms at non-peak travel times without diluting the image of their brand. These types of websites have become popular with travelers looking for a discount – usually in the 35-60% range.

Furthermore, cash strapped adventure seekers can opt for the tiny hotel room concept. This hotel type is for those who spend their vacations on foot and sight-seeing rather than in their room. Travelers can expect a 30-40% decrease in price over standard hotel rooms. Such a concept is typically heavily traveled cities like New York and Tokyo.



In attempt to lure wary travelers, hotels are also ramping up their level of service and amenities, usually at no additional expense. Consumers demand items such as flat screen TV’s and Wi-Fi – items which were once considered a luxury. Hotels are trending towards a more personal touch, better check-in service and will cater to individual needs as a way to set themselves apart from competition.

Consumers are looking for a more unique experience and are more cautious with their hard earned dollars. Boutique hotels are becoming more popular as consumers move away from the one-size-fits-all mega hotel. Patrons will typically receive a more attentive level of service and amenities. Hotels are also cashing in on catering to specific likes of travelers. Theme hotels for Star Trek, Star Wars and Jurassic Park have a strong enough niche to remain viable. Some boutique hotels are even offering an “unplugged” vacations which provides no TV, no Wi-Fi, and no in-room telephone – a sort of digital detox.


Hotel owners in major US destinations such as New York, Boston, and Miami have been surprised by the uptick in demand and how quickly it has returned. Some industry experts predict average daily room rates to increase by 5% in 2011 as leverage slowly shifts back from the consumer to operator. Another factor in the increased rates is the slowdown in new hotel construction which limits competition.

As consumers begin to travel again there will be plenty of options in terms of destinations, themed hotels, boutique hotels, and hotel types for all kinds of travelers.

Trends in Industrial Market and Taxes - Class 4

Industrial

The decrease in consumer spending in retail has led to retailers being cautious of their warehouse inventories leading to a slow recovery in the industrial market. Retailers have begun opting for just-in-time supply chains rather than warehousing product. Distribution centers and warehouse space has seen an uptick in leasing activity, however, these leases are more short term, 6 months or less, than long term leases; a sign that retailers may be gearing up for the holiday season. Warehouse owners are agreeing to these deals with hopes of turning the lease into a long term tenant. Analysts are still unsure if this year’s leases are a rebuilding of depleted inventory or business growth.

As a result of negative absorption and reduced demand for industrial space has led to a decrease in rental rates. NREI reports effective rent fell 6.5% in 2009 to $4.35 per square foot and decreased 3.7% to $4.19 in 2010.

Some industrial owners have become creative in leasing out their space. Owner’s of industrial buildings from the 1940’s and 1950’s who can no longer compete with the large distribution hubs are seeking out fringe tenants. These tenants are typically artists such as painters, photographers, and musicians who benefit from large studio space at a relatively cheap rate. This creates a win-win situation for both the owner and tenant. The owner has cash flow and a tenant who feels pride in the building while the tenant is able to operate their business at a fraction of the cost of newer office or industrial space.

Taxes

A result of property appraisals decreasing and an overall poor economy, cities have seen their tax base shrinking. To combat this drop in revenue, states are downsizing and slashing costs. A large part of this measure is a reduction in office space needs for governmental uses. Analysts at J.P. Morgan Chase have noted that REIT’s with large portion of governmental assets should be watched more closely as renewals are not guaranteed.

It’s been reported that state tax collection has decreased by 2% in the 2010 fiscal year. This amounts to a decrease of $14.3 billion which follows a decrease of $65.8 billion in 2008, according to NREI.

States have increased their search for additional taxes on real estate. One area that receives great tax treatment is property with agricultural status. The benefit in question is the ability of land with agricultural status to be tax at use value rather than market value. The difference, which can be fairly significant, can make a sizeable dent in the bottom line of investors. The target of state tax assessors will impact developers who hold land for future development who use the agricultural status to lessen the burden of holding for an extended period of time.