How Commercial Real Estate Lender’s view Collateral by Property Type
Commercial Real Estate can largely be broken out into four different product types: Multifamily, Retail, Office and Industrial. Within each of these property types there lies specializations, nuances and combinations that make up the commercial real estate sector.
Each product type varies by use, which dictates its physical characteristics, return profile, and demand within a specified market. Below, are points outlining how lenders and the general market characterize each type of commercial real estate and where strengths & opportunities, as well as potential risk, exist.
Safest Asset Class by Occupancy
Multifamily properties, so long as they are in habitable condition, will always be able to be rented to a tenant (should the rent level be compelling and meet the market). Housing is a much higher human need than owning/running a business which inherently creates a higher demand for this property type. A real estate owner will always able to lower rents to get a unit occupied. Due to this, it is perceived as one of the safest asset classes by type and the ability to generate income.
Short Lease Periods
Multifamily assets typically have lease periods that are 12-month terms and then become month-to-month thereafter. The short-term nature of the lease(s) allows landlords to keep rents at market levels (assuming there is no rent control provision in the region where the asset is located).
Management & Capital Intensive. Highest Level of Turnover (on a recurring basis)
Most lease terms are 12 months and go to a month-to-month term thereafter leaving predictability of income less certain. Additionally, upon a unit coming available for lease, property owners/managers must go through the unit (often on an annual basis) and clean/paint/perform preventative maintenance - as needed - in order to ensure the property is in leaseble condition for the next tenant. This “downtime” adds time to the unit being vacant and can be considered lost income due to the unit being vacant (captured by modeling vacancy within the cashflow) with no guarantee for the unit to be leased by a specified date.
Subject to more regulation - Section 8, rent control, inspection etc.
Due to the property being residential it is subject to more oversight from governmental agencies requiring landlords to maintain properties in habitable condition. While this requires more proactive management, the relative ease of leasing helps to alleviate negative cash flow. Additionally there is government-subsidized housing whereby tenants’ rent is paid by the government, directly, significantly increasing the credit profile and predictability of cashflows of the property.
Tax Depreciation Schedule
Multi-Family properties are able to be depreciated at a faster rate (as low as 27.5 years) than other commercial properties (39 years) providing significant tax-advantaged returns. This allows for multifamily real estate owners the ability to write off the “wear and tear” of the asset at a faster rate than commercial assets to save in taxes. Essentially this depreciation can be viewed as an ice-cube, whereby the value of the improvements on property (that is everything but the land) is divided among the amount of years (in this case 27.5). This decreased time period allows for a larger percentage of value to be written off each year, saving on taxes that would have to be paid to the government.
Commercial real estate properties (i.e. Retail, Office, & Industrial) are distinctly different from Multifamily in that their primary purpose is to “house” a business rather than people. Due to this, commercial assets have distinctly different physical characteristics that also affect the way they operate and generate cash flow. Commercial properties are typically leased to companies and/or individuals for a longer period of time (typically between 3-10 years) with stated rental amount(s), escalations, expense reimbursement provisions, allowed uses, etc. Additionally, there are often leasing brokers that are involved in either representing a tenant or a landlord whom are paid a commission to secure a tenant. There also may be additional concessions from a landlord to incentivize tenants to occupy their building in the form of Tenant Improvement(s) - monies that are allocated to improve a space to be more tailored to the business’ needs.
Commercial properties are often seen as less management intensive than the multifamily asset class and typically have a more predictable stream of cashflows - largely due to their lease structure(s). However, one must look at the credit and strength of the underlying tenancy to measure the “bankability” of the projected income stream. Credit/Vacancy loss typically will be modeled on all in-place tenancy to account for any interruptions in occupancy/cashflow to provide a conservative operating budget for real estate holdings. Below are some characteristics and considerations lenders have regarding the various types of commercial (non-multifamily) real estate
Properties are largely reliant on two factors - location, but more importantly concept.
Retail is the only property type that is truly public-facing and requires the business operating within the space to appeal to consumers and serve the needs of the immediate area. Additionally, if a business operating within a space is a national company - there lies significant risk in ensuring that a concept that works well in Los Angeles is just as appealing in Kansas City. It is the geographic and demographic differences from market-to-market where retail faces its biggest challenge, and therefore credit risk
Harsh Outlook Creates Potential Overlooked Opportunities
Retail by and large is a risky asset type, however this cycle, retail has been significantly over-sold as an “untouchable” asset class. While this convention may largely be true, there still are “ground zero” retail locations where vacancies continue to stay extremely low, rent growth persists, and demand is ever-present. It is these sorts of retail properties where there lies opportunity for extra yield due to the bearish outlook on the product. There will always be “main & main” locations where retail properties/concepts will be successful due to density and foot traffic.
Retail Properties & Potential for Adaptive Reuse
Retail properties are often located in irreplaceable location(s) that would be ripe for an adaptive reuse - especially if permitted zoning for a property will allow for alternative uses. In recent years, one of the most common conversions of retail has been converting them into distribution facilities and “last mile” fulfillment centers. Often times properties become functionally obsolescent and require significant capital infusion in order to become economically viable and serve market demands.
Co-Tenancy & Go Dark Provisions
Retail properties are slightly unique in that oftentimes an “anchor tenant” will have significant input into the future of the center. For instance if there is a grocery store that is located at a shopping center, there may be - as a condition of their lease - a provision that would preclude the landlord from leasing any additional space to a competitor.
Defined Lease Terms
Office tenancy, like other commercial buildings, can have a rent roll with tenants whose leases expire on a staggered basis - that is not all in-place tenant’s leases expire at the same time (or year). This increases the stability of the asset (and the underlying cashflow stream) and is much more appealing to Lenders who value the durability and diversification of a property’s income.
Diversification of Rent Roll by Tenant-Related Industry
One benefit of office buildings is the ability to diversify the tenant mix by selecting companies whose primary business services a wide spectrum of different industries. A building owner can have tenants that serve the energy sector, technology industry, media and just about anything else that helps to insulate the income stream from outside downturns that can decimate a singular industry sector.
Commercial buildings, especially office, are subject to concentration risk whereby a certain tenant can occupy a disproportionate amount of the Net Rentable Area (NRA) compared to the remainder of the tenancy and expose a building owner to outsized rollover risk. For instance, as a business grows and occupies more space within a building, the building becomes much more dependent on and tied to the success of one tenant, rather than relying on several smaller companies to spread risk of default around.
Changing Work Environments & Norms - Collaboration Space & Telecommuting
Office properties are undergoing a radical shift in the way they are built and “improved”. The modern-day office-using workforce has radically different requirements for their space than what tenants demanded just over a decade ago. Floor plans consisting of perimeter offices with an interior “bull-pen” space are no longer desired. Instead, “open concept” collaborative space is now in vogue and tenants are drawn willingly to pay much higher rents for these types of build outs. Additionally, the rise of telecommuting jobs has forced businesses and landlords alike to shift the way they design and plan for space requirements to provide for their employees.
Property Type that is least Capital Intensive
Warehouse properties can be generally characterized as a large, enclosed space where a variety of shipping, manufacturing, distribution activities are performed. Industrial buildings typically have less robust tenant improvements or custom/specialized build outs that would not include affixed features or FF&E. Upon tenant rollover, the capital required to re-lease the space is typically less than other product types.
Asset Class has become Increasingly more Sought After
The industrial asset class has been the darling of this past economic expansionary cycle with exploding demand being generated from e-commerce & third-party logistics firms (3PL’s) satisfying online consumer shopping habits. The desire for well-located industrial space that can satisfy the “last mile” of fulfillment to customers has continued to increase with rents reaching levels previously thought unattainable. The quest for achieving the quickest “click-to-delivery” service has forced businesses and industrial owners alike to re-think where industrial makes sense in markets previously passed over.
Often industrial properties share the same concentration risk as other commercial properties whereby a disproportionate share of income/NRA is occupied by a singular tenant, greatly increasing rollover/default risk.
Between the Multifamily and Commercial property type(s) there lies the Hospitality asset class that blends elements of the two types together. Hospitality hotels have a “residential” element to them in that they house/lodge individuals and a “commercial” factor that involves their brand, affects their operations and overall perception within the market. When a lender finances a hospitality property they are not only looking at the physical real estate and Borrower, but also the business and “flag” or brand of the hotel. Hotel properties must serve the local market in which they are located as their nature of attracting temporary residents relies heavily on the demand in the area. For instance a 5-star hotel located along a roadside stop with little-to-no nearby amenities or attractions will likely fail as there will be little demand for that type of hotel in that demographic. Alternatively a hospitality concept geared towards value and convenience for the likely transient hotel guests will have a better chance of succeeding in the aforementioned location. Additionally, the personnel involved in operating a hotel are paramount to its success. Due to the service-oriented nature of the product type, not only does the physical collateral need to be in excellent condition, but the corresponding experience provided by the hotel staff. Hospitality properties have different levels of service (i.e. Limited Service, Fully Service) etc., which tie back to the quality and professionalism of the staff. The more services and amenities provided by the hotel, the more reliant the property’s success is on the personnel, including but not limited to expense management, marketing efforts, turndown service, repairs & maintenance and meals, catering & entertainment.
All commercial real estate has benefits and detractors based on the property type. It is dependent on the skill, management and vision of a property owner to ensure that a property is well run and poised to compete advantageously given a specific market. When investing in commercial real estate, one must evaluate more than just the cashflow, but also consider the management considerations, tax implications, and overall market risk. Commercial real estate investing can be a lucrative avenue to place capital - but it requires a disciplined plan to execute successfully.
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