Deutsche Bank Commercial Real Estate Outlook Q4 2008

Deutsche Bank has released their latest real estate outlook report.  No big surprises here.   Loan deliquency rates are going up.  Mutifamily looks the worst, followed by hotel and then retail. Office loans don't look too bad yet, and Industrial still looks ok.

The real story comes on pages 18, 22 & 23.  Page 18 shows the drastic decline in property prices. Declines in prices aren't a big deal for owners that have owned and plan to own their buildings for a long time.  However, many of the country's biggest and most expensive buildings have changed hands in the last couple of years, for top dollar - particularly in NY.  Many of these properties are in trouble as their short term loans are coming due, and the landlords who were counting on ever increasing rents and very low vacancy rates to refinance these properties won't be able to refinance.  

In fact, if you look at page 22, you'll see that a huge share of the loans maturing in the next few years are interest only - very scary! The remaining pages show that borrowers are already having trouble refinancing these loans and it's only expected to get worse.

Ultimately, I think that it's fair to say that NY will be hit very hard by the inability to refinance loans.  In a future post I'll explain why in detail, but here's the jist of it.  Buyers of office towers in NYC have bought buildings with increasing small "cap rates" (basically the annual predicted profit margin, or the percentage return per year as determined by dividing the Net Operating Income by the Sales Price).  This leaves very little "room for error." If vacancy rates go up, expenses go up, or rents go down . . . even a little bit, the profit dissapears, the slightest bit more, and the buildings are losing money.  Buildings that bring in less money are worth less, refinancing a building when you owe more than the building is worth is awfully tough!

Without further ado, here's the Deutsche Bank Report.

Here's a great note from my friend Peter - Thanks!:

Don't be so surprised that the loans that are defaulting are the IOs, as IOs are typically bridge/construction which got crushed. Longer term loans typically are likely less speculative in their underwriting. As for the cap rates, what you didn't mention was the idea that said cap rates were "synthetic" and were anticipated to increase as soon as rents rolled. Unfortunatly, due to market conditions, rents have not only not increased as anticipated, but have decreased (perfect storm) which has lowered caps even further (and in turn, caused defaults).

Asking Rents Drop, Taking Rents Tumble: Great Research from G&E

In advance of posting the Grubb & Ellis market report for the month of December, I thought it would be helpful to explain what Net Effective Rents are, which I did in my last post.

Now that you have this wonderful knowledge, here is the latest report which goes into more detail on market and breaks down asking rents on a direct and sublet basis. By the way, the difference between direct and sublet asking rents: 27%!!

If you've been thinking about when to take advantage of this crazy market, now is the time. Without any further ado, here's the report:

Asking Rents & Even Taking Rents Don't Tell The Full Story

In some of my recent posts (ok, not that recent) I've shared some of Grubb & Ellis' research on what's going on with the market. Many people have mentioned to me, that they are suprised by how little asking rents have dropped. With that mind, I thought now would be a good time to talk about Net Effective Rents.

Net Effective Rents are simply, the rent that a lessee or sublessee pays once you "net out" all of the concessions made by the landlord or sublandlord and average out the rent bumps. Here's an example:

Joe makes a deal on a space in Midtown. The landlord on the space is asking $70 a SF (per year) for a 10,000 SF space. Joe likes it, but recognizes that this rent is much higher than the current market for that kind of space. Joe's astute broker, Michael realizes that the landlord is under pressure from his investors to rent his space for as high a price as possible. He suggests to Joe, that he put in an offer close to the asking price but with lots of concessions to bring the overall cost down.

Ultimately, Michael negotiates a 10 year deal for Joe where he pays $65 a foot for the first 5 years and $67 a foot for the second 5 years. Joe will also get $75 a foot in Tenant Installation allowance, and 10 months free rent.

Joe's new landlord goes back to his investors and tells them that he made a deal with an average rent of $66. Not far off his asking price of $70. However, let's look at the Net Effective Rent, shall we?:

The value of 10 Months free rent: $5.42/SF

The value of $75 a foot in TI (Tenant Installation $): $7.50/SF

Net Effective Rent: Average of $65 for 5 years and $67 for 5 years = $66 - $5.42 free rent - $7.50 TI = $53.08

Now, this is obviously a simplified model, as I didn't account for the time value of money. If I did, you would find that the landlord did even worse. I also made the assumption that all of the free rent was up front, which is not always the case, and I assumed that the term wasn't extended to account for the free rent.

The point of this example was to show you, what's really happening in the NY market right now. Asking rents may only be down 3.7% from their peak, but taking rents are down 9% and net effective rents are down 12.6%. This trend will surely continue well in to 2009 and expect to see much larger discounts on sublets than on direct space.